SBSI 6.30.2013 10-Q/A
Table of Contents


 
 
 
 
 
UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q/A
Amendment No. 1
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2013

OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ____________ to ____________
 
Commission file number 0-12247
SOUTHSIDE BANCSHARES, INC.
(Exact name of registrant as specified in its charter)
TEXAS
 
75-1848732
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
 
 
 
1201 S. Beckham, Tyler, Texas
 
75701
(Address of principal executive offices)
 
(Zip Code)
903-531-7111
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x    No  o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  x    No  o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):
Large accelerated filer o
Accelerated filer x
Non-accelerated filer o
Smaller reporting company o
(Do not check if a smaller reporting company)
 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No x

The number of shares of the issuer's common stock, par value $1.25, outstanding as of July 31, 2013 was 17,866,716 shares.
 



Explanatory Note

This Amendment No. 1 on Form 10-Q/A amends the Quarterly Report on Form 10-Q for the period ended June 30, 2013, which was originally filed with the Securities and Exchange Commission (the “SEC”) on August 7, 2013 (the “Original Filing”). This amendment is being filed to reflect the restatement of i) the quarterly results of Southside Bancshares, Inc. (the “Company”), as discussed in Note 2 to the unaudited consolidated financial statements contained herein, and ii) other information related to such restated financial information. Except for Items 1, 2 and 4 of Part I and Item 6 of Part II, no other information included in the Original Filing is amended by this Form 10-Q/A.
During the preparation of the Form 10-K for the year ended December 31, 2013 (the “2013 Form 10-K”), the Company determined that in periods prior to December 31, 2013, it incorrectly accounted for the recognition of interest income on its municipal bonds purchased at a premium based on amortizing the premium to the earliest call date instead of amortizing the premium to maturity as prescribed pursuant to GAAP. Therefore, the Company determined the municipal bonds purchased at a premium should be re-amortized to maturity.
The Company evaluated the effect of this error and concluded that it was immaterial to any of the previously issued consolidated financial statements except for the unaudited consolidated financial statements included in the Company’s Quarterly Reports on Form 10-Q for the periods ended March 31, June 30, and September 30, 2013. Accordingly, on February 10, 2014, the Company filed a Form 8-K reporting that the Audit Committee of the Board of Directors of the Company determined based on the recommendation of management, that the Company should restate its unaudited consolidated financial statements in each of these Quarterly Reports on Form 10-Q. In addition, the Company will record, in the fourth quarter of 2013, the immaterial cumulative effect of the error relating to prior years, which will increase net income by approximately $1.1 million for the year ended December 31, 2013.
See Note 2 – Restatement to Previously Issued Financial Statements contained in the Notes to Financial Statements included in this Form 10-Q/A which further describes the effect of this restatement.
Pursuant to Rule 12b-15 of the Securities Exchange Act of 1934, as amended, this Form 10-Q/A includes new certifications by our principal executive officer and principal financial officer under Sections 302 and 906 of the Sarbanes-Oxley Act of 2002. Except for the items noted above, no other information included in the Original Filing is being amended by this Form 10-Q/A. This Form 10-Q/A continues to speak as of the date of the Original Filing and we have not updated the filing to reflect events occurring subsequent to the date of the Original Filing other than those associated with the restatement of the Company’s financial statements. Accordingly, this Form 10-Q/A should be read in conjunction with the Company’s filings with the SEC subsequent to the Original Filing, including any amendments to those filings.


TABLE OF CONTENTS
 
PART I.  FINANCIAL INFORMATION
 
PART II.  OTHER INFORMATION
 
EXHIBIT 31.1 – CERTIFICATION PURSUANT TO SECTION 302
 
EXHIBIT 31.2 – CERTIFICATION PURSUANT TO SECTION 302
 
EXHIBIT 32 – CERTIFICATION PURSUANT TO SECTION 906
 


Table of Contents


PART I.   FINANCIAL INFORMATION
ITEM 1.   FINANCIAL STATEMENTS
SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(in thousands, except share amounts)
 
June 30,
2013
 
December 31,
2012
ASSETS
(Restated)
 
 
Cash and due from banks
$
45,628

 
$
47,312

Interest earning deposits
4,169

 
103,318

Total cash and cash equivalents
49,797

 
150,630

Investment securities:
 

 
 

Available for sale, at estimated fair value
488,321

 
617,707

Held to maturity, at amortized cost
302,994

 
1,009

Mortgage-backed and related securities:
 

 
 

Available for sale, at estimated fair value
821,760

 
806,360

Held to maturity, at amortized cost
240,514

 
245,538

FHLB stock, at cost
27,153

 
27,889

Other investments, at cost
2,064

 
2,064

Loans held for sale
724

 
3,601

Loans:
 

 
 

Loans
1,293,429

 
1,262,977

Less:  Allowance for loan losses
(18,370
)
 
(20,585
)
Net Loans
1,275,059

 
1,242,392

Premises and equipment, net
50,186

 
50,075

Goodwill
22,034

 
22,034

Other intangible assets, net
245

 
324

Interest receivable
20,883

 
18,936

Deferred tax asset
21,478

 
4,120

Unsettled issuances of brokered CDs
11,069

 

Other assets
51,384

 
44,724

TOTAL ASSETS
$
3,385,665

 
$
3,237,403

LIABILITIES AND SHAREHOLDERS’ EQUITY
 

 
 

Deposits:
 

 
 

Noninterest bearing
$
663,594

 
$
595,093

Interest bearing
1,835,744

 
1,756,804

Total deposits
2,499,338

 
2,351,897

Short-term obligations:
 

 
 

Federal funds purchased and repurchase agreements
857

 
984

FHLB advances
84,882

 
150,985

Other obligations
219

 
219

Total short-term obligations
85,958

 
152,188

Long-term obligations:
 

 
 

FHLB advances
441,808

 
369,097

Long-term debt
60,311

 
60,311

Total long-term obligations
502,119

 
429,408

Unsettled trades to purchase securities
27,814

 
10,047

Other liabilities
34,316

 
36,100

TOTAL LIABILITIES
3,149,545

 
2,979,640

 
 
 
 
Off-Balance-Sheet Arrangements, Commitments and Contingencies (Note 11)


 


 
 
 
 
Shareholders' equity:
 

 
 

Common stock ($1.25 par, 40,000,000 shares authorized, 20,335,929 shares issued in 2013 and 19,446,187 shares issued in 2012)
25,420

 
24,308

Paid-in capital
212,648

 
195,602

Retained earnings
66,732

 
70,708

Treasury stock (2,469,638 and 2,379,338 shares at cost)
(37,692
)
 
(35,793
)
Accumulated other comprehensive (loss) income
(30,988
)
 
2,938

TOTAL SHAREHOLDERS' EQUITY
236,120

 
257,763

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
$
3,385,665

 
$
3,237,403

The accompanying notes are an integral part of these consolidated financial statements.

1

Table of Contents


SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
(in thousands, except per share data)
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2013
 
2012
 
2013
 
2012
Interest income
 (Restated)
 
 
 
(Restated)
 
 
Loans
$
18,390

 
$
17,526

 
$
36,055

 
$
34,296

Investment securities – taxable
169

 
20

 
533

 
51

Investment securities – tax-exempt
5,907

 
2,961

 
10,395

 
5,628

Mortgage-backed and related securities
4,680

 
8,872

 
8,616

 
21,035

FHLB stock and other investments
34

 
54

 
99

 
133

Other interest earning assets
35

 
9

 
78

 
15

Total interest income
29,215

 
29,442

 
55,776

 
61,158

Interest expense
 

 
 

 
 

 
 

Deposits
2,001

 
2,765

 
4,071

 
6,160

Short-term obligations
389

 
1,734

 
1,639

 
3,326

Long-term obligations
1,954

 
2,398

 
3,735

 
5,131

Total interest expense
4,344

 
6,897

 
9,445

 
14,617

Net interest income
24,871

 
22,545

 
46,331

 
46,541

Provision for loan losses
2,021

 
2,174

 
2,513

 
5,226

Net interest income after provision for loan losses
22,850

 
20,371

 
43,818

 
41,315

Noninterest income
 

 
 

 
 

 
 

Deposit services
3,904

 
3,838

 
7,657

 
7,586

Gain on sale of securities available for sale
5,001

 
3,297

 
9,346

 
9,269

Loss on sale of securities carried at fair value through income

 
(13
)
 

 
(498
)



 


 


 


Total other-than-temporary impairment losses

 
(21
)
 
(52
)
 
(21
)
Portion of loss recognized in other comprehensive income (before taxes)

 
(19
)
 
10

 
(160
)
Net impairment losses recognized in earnings

 
(40
)
 
(42
)
 
(181
)



 


 


 


FHLB advance option impairment charges

 
(1,364
)
 

 
(1,836
)
Gain on sale of loans
241

 
298

 
560

 
429

Trust income
733

 
669

 
1,453

 
1,346

Bank owned life insurance income
264

 
254

 
518

 
520

Other
953

 
1,123

 
1,844

 
2,234

Total noninterest income
11,096

 
8,062

 
21,336

 
18,869

Noninterest expense
 

 
 

 
 

 
 

Salaries and employee benefits
13,401

 
12,142

 
26,610

 
23,975

Occupancy expense
1,897

 
1,851

 
3,768

 
3,609

Advertising, travel & entertainment
656

 
603

 
1,297

 
1,207

ATM and debit card expense
303

 
287

 
684

 
566

Director fees
273

 
273

 
537

 
541

Supplies
169

 
222

 
419

 
381

Professional fees
562

 
612

 
1,202

 
1,303

Telephone and communications
384

 
445

 
835

 
851

FDIC insurance
409

 
414

 
830

 
884

FHLB prepayment fees
988

 

 
988

 

Other
2,124

 
2,247

 
4,315

 
4,301

Total noninterest expense
21,166

 
19,096

 
41,485

 
37,618

 
 
 
 
 
 
 
 
Income before income tax expense
12,780

 
9,337

 
23,669

 
22,566

Provision for income tax expense
1,712

 
1,608

 
3,559

 
4,698

Net income
$
11,068

 
$
7,729

 
$
20,110

 
$
17,868

Earnings per common share – basic
$
0.62

 
$
0.42

 
$
1.13

 
$
0.98

Earnings per common share – diluted
$
0.62

 
$
0.42

 
$
1.12

 
$
0.98

Dividends paid per common share
$
0.20

 
$
0.20

 
$
0.40

 
$
0.38

The accompanying notes are an integral part of these consolidated financial statements.

2

Table of Contents


SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(UNAUDITED)
(in thousands)
 
Three Months Ended
 
Six Months Ended

June 30,
 
June 30,
 
2013
 
2012
 
2013
 
2012
 
(Restated)
 
 
 
(Restated)
 
 
Net income
$
11,068

 
$
7,729

 
$
20,110

 
$
17,868

Other comprehensive income (loss):
 

 
 

 
 

 
 

Unrealized holding (losses) gains on available for sale securities during the period
(38,536
)
 
842

 
(44,280
)
 
(4,044
)
Change in net unrealized gain on securities transferred to held to maturity
28

 

 
28

 

Noncredit portion of other-than-temporary impairment losses on the AFS securities

 
40

 
(10
)
 
181

Reclassification adjustment for gain on sale of available for sale securities, included in net income
(5,001
)
 
(3,297
)
 
(9,346
)
 
(9,269
)
Reclassification of other-than-temporary impairment charges on available for sale securities, included in net income

 
40

 
42

 
181

Amortization of net actuarial loss, included in net periodic benefit cost
751

 
512

 
1,394

 
1,011

Amortization of prior service credit, included in net periodic benefit cost
(11
)
 
(12
)
 
(22
)
 
(22
)
Other comprehensive loss, before tax
(42,769
)
 
(1,875
)
 
(52,194
)
 
(11,962
)
Income tax benefit related to other items of comprehensive income
14,969

 
656

 
18,268

 
4,187

Other comprehensive loss, net of tax
(27,800
)
 
(1,219
)
 
(33,926
)
 
(7,775
)
Comprehensive (loss) income
$
(16,732
)
 
$
6,510

 
$
(13,816
)
 
$
10,093


The accompanying notes are an integral part of these consolidated financial statements.

3

Table of Contents


SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY
(UNAUDITED)
(in thousands, except share and per share data)
 
Common
Stock
 
Paid In
Capital
 
Retained
Earnings
 
Treasury
Stock
 
Accumulated
Other
Comprehensive
Income (Loss)
 
Total
Shareholders'
Equity
Balance at December 31, 2011
$
23,146

 
$
176,791

 
$
72,646

 
$
(28,377
)
 
$
14,721

 
$
258,927

Net Income
 

 
 

 
17,868

 
 

 
 

 
17,868

Other comprehensive loss
 

 
 

 
 

 
 

 
(7,775
)
 
(7,775
)
Issuance of common stock (30,436 shares)
38

 
595

 
 

 
 

 
 

 
633

Stock compensation expense
 

 
133

 
 

 
 

 
 

 
133

Tax benefits of incentive stock options
 

 
11

 
 

 
 

 
 

 
11

Net issuance of common stock under employee stock plans
10

 
39

 
(54
)
 
 
 
 
 
(5
)
Cash dividends paid on common stock ($0.38 per share)
 

 
 

 
(6,436
)
 
 

 
 

 
(6,436
)
Stock dividend declared
1,034

 
16,425

 
(17,459
)
 
 

 
 

 

Balance at June 30, 2012
$
24,228

 
$
193,994

 
$
66,565

 
$
(28,377
)
 
$
6,946

 
$
263,356

 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2012
$
24,308

 
$
195,602

 
$
70,708

 
$
(35,793
)
 
$
2,938

 
$
257,763

Net Income (Restated)
 

 
 

 
20,110

 
 

 
 

 
20,110

Other comprehensive loss (Restated)
 

 
 

 
 

 
 

 
(33,926
)
 
(33,926
)
Issuance of common stock (28,529 shares)
35

 
593

 
 

 
 

 
 

 
628

Purchase of common stock (90,300 shares)
 
 
 
 
 
 
(1,899
)
 
 
 
(1,899
)
Stock compensation expense
 

 
373

 
 

 
 

 
 

 
373

Tax benefits related to stock awards
 

 
22

 
 

 
 

 
 

 
22

Net issuance of common stock under employee stock plans
12

 
63

 
(62
)
 
 

 
 

 
13

Cash dividends paid on common stock ($0.40 per share)
 

 
 

 
(6,964
)
 
 

 
 

 
(6,964
)
Stock dividend declared
1,065

 
15,995

 
(17,060
)
 
 

 
 

 

Balance at June 30, 2013 (Restated)
$
25,420

 
$
212,648

 
$
66,732

 
$
(37,692
)
 
$
(30,988
)
 
$
236,120


The accompanying notes are an integral part of these consolidated financial statements.

4

Table of Contents


SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW
(UNAUDITED)
(in thousands)
 
Six Months Ended
 
June 30,
 
2013
 
2012
OPERATING ACTIVITIES:
(Restated)
 
 
Net income
$
20,110

 
$
17,868

Adjustments to reconcile net income to net cash provided by operations:
 

 
 

Depreciation
1,807

 
1,778

Amortization of premium
16,015

 
22,864

Accretion of discount and loan fees
(2,852
)
 
(2,399
)
Provision for loan losses
2,513

 
5,226

Stock compensation expense
373

 
133

Deferred tax expense (benefit)
909

 
(2,743
)
Excess tax benefits from stock-based compensation
(22
)
 
(11
)
Loss on sale of securities carried at fair value through income

 
498

Gain on sale of securities available for sale
(9,346
)
 
(9,269
)
Net other-than-temporary impairment losses
42

 
181

FHLB advance option impairment charges

 
1,836

Gain on sale of other real estate owned
(72
)
 
(3
)
Net change in:
 

 
 

Interest receivable
(1,947
)
 
1,497

Other assets
(6,990
)
 
27

Interest payable
(481
)
 
(458
)
Other liabilities
69

 
(2,393
)
Loans held for sale
2,877

 
2,105

Net cash provided by operating activities
23,005

 
36,737

 
 
 
 
INVESTING ACTIVITIES:
 

 
 

Securities held to maturity:
 

 
 

Purchases
(115,647
)
 

Maturities, calls and principal repayments
118,178

 
32,331

Securities available for sale:
 

 
 

Purchases
(1,018,900
)
 
(1,213,923
)
Sales
612,459

 
448,725

Maturities, calls and principal repayments
179,203

 
163,809

Securities carried at fair value through income:
 

 
 

Purchases

 
(57,606
)
Sales

 
675,255

Maturities, calls and principal repayments

 
25,279

Proceeds from redemption of FHLB stock
5,242

 
10,292

Purchases of FHLB stock and other investments
(4,506
)
 
(10,757
)
Net increase in loans
(35,355
)
 
(100,529
)
Purchases of premises and equipment
(1,918
)
 
(1,433
)
Proceeds from sales of premises and equipment

 

Proceeds from sales of other real estate owned
461

 
112

Proceeds from sales of repossessed assets
2,304

 
2,070

Net cash used in investing activities
(258,479
)
 
(26,375
)
 
 
 
 
(continued)
 
 
 

5

Table of Contents


SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW
(UNAUDITED) (continued)
(in thousands)
 
Six Months Ended
 
June 30,
 
2013
 
2012
FINANCING ACTIVITIES:
(Restated)
 
 
Net increase in demand and savings accounts
$
140,307

 
$
198,420

Net decrease in certificates of deposit
(3,947
)
 
(124,695
)
Net decrease in federal funds purchased and repurchase agreements
(127
)
 
(997
)
Proceeds from FHLB advances
6,792,758

 
9,133,164

Repayment of FHLB advances
(6,786,150
)
 
(9,147,464
)
Excess tax benefits from stock-based awards
22

 
11

Net issuance of common stock under employee stock plan
13

 

Purchase of common stock
(1,899
)
 

Proceeds from the issuance of common stock
628

 
633

Cash dividends paid
(6,964
)
 
(6,436
)
Net cash provided by financing activities
134,641

 
52,636

 
 
 
 
Net (decrease) increase in cash and cash equivalents
(100,833
)
 
62,998

Cash and cash equivalents at beginning of period
150,630

 
43,238

Cash and cash equivalents at end of period
$
49,797

 
$
106,236

 
 
 
 
 
 
 
 
SUPPLEMENTAL DISCLOSURES FOR CASH FLOW INFORMATION:
 

 
 


 
 
 
Interest paid
$
9,925

 
$
15,075

Income taxes paid
$
1,600

 
$
9,200

 
 
 
 
SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND FINANCING ACTIVITIES:
 

 
 


 
 
 
Loans transferred to other repossessed assets and real estate through foreclosure
$
2,555

 
$
2,621

Transfer of available for sale securities to held to maturity securities
$
290,136

 
$

Adjustment to pension liability
$
(1,372
)
 
$
(989
)
5% stock dividend
$
17,060

 
$
17,459

Unsettled trades to purchase securities
$
(27,814
)
 
$
(42,300
)
Unsettled trades to sell securities
$

 
$
1,071

Unsettled issuances of brokered CDs
$
11,069

 
$


The accompanying notes are an integral part of these consolidated financial statements.


6

Table of Contents


SOUTHSIDE BANCSHARES, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS

1.    Basis of Presentation

In this report, the words “the Company,” “we,” “us,” and “our” refer to the combined entities of Southside Bancshares, Inc. and its subsidiaries.  The words “Southside” and “Southside Bancshares” refer to Southside Bancshares, Inc.  The words “Southside Bank” and “the Bank” refer to Southside Bank. “FWBS” refers to Fort Worth Bancshares, Inc., a bank holding company acquired by Southside. “SFG” refers to SFG Finance, LLC (formerly Southside Financial Group, LLC) which is a wholly-owned subsidiary of the Bank as of July 15, 2011.

As mentioned in our 10-K for the year ended December 31, 2012, we made a decision to close Southside Securities, Inc. The closure was completed during the second quarter of 2013.

The consolidated balance sheet as of June 30, 2013, and the related consolidated statements of income, comprehensive income, changes in equity and cash flows and notes to the financial statements for the three- and six-month periods ended June 30, 2013 and 2012 are unaudited; in the opinion of management, all adjustments necessary for a fair statement of such financial statements have been included.  Such adjustments consisted only of normal recurring items.  All significant intercompany accounts and transactions are eliminated in consolidation.  The preparation of these consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires the use of management’s estimates.  These estimates are subjective in nature and involve matters of judgment.  Actual amounts could differ from these estimates.

Interim results are not necessarily indicative of results for a full year.  These financial statements should be read in conjunction with the financial statements and notes thereto in our Annual Report on Form 10-K for the year ended December 31, 2012.  For a description of our significant accounting and reporting policies, refer to Note 1 of the Notes to Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2012. Additionally, we add the following to our significant accounting and reporting policies: For securities purchased at a premium or discount the recognition of interest income on an individual security is accounted for by amortizing the premium or discount to the maturity of that security.

On March 28, 2013 our board of directors declared a 5% stock dividend to common stock shareholders of record as of April 18, 2013, which was paid on May 9, 2013. All share data has been adjusted to give retroactive recognition to stock dividends.  

Accounting Pronouncements

ASU 2011-11, “Balance Sheet (Topic 210) – Disclosures about Offsetting Assets and Liabilities.”  ASU 2011-11 amends Topic 210, “Balance Sheet,” to require an entity to disclose both gross and net information about financial instruments, such as sales and repurchase agreements and reverse sale and repurchase agreements and securities borrowing/lending arrangements, and derivative instruments that are eligible for offset in the statement of financial position and/or subject to a master netting arrangement or similar agreement.  We adopted ASU 2011-11 on January 1, 2013, and it did not have a significant impact on our consolidated financial statements.

ASU 2013-02, “Comprehensive Income (Topic 220) – Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” ASU 2013-02 requires entities to provide information about the significant amounts reclassified out of accumulated other comprehensive income by component. This update also requires companies to disclose the income statement line items impacted by any significant reclassifications. We adopted ASU 2013-02 on January 1, 2013, and it did not have a significant impact on our consolidated financial statements.


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2.
Restatement of Previously Issued Financial Statements
During the preparation of the 2013 Form 10-K, we determined that in periods prior to December 31, 2013, we incorrectly accounted for the recognition of interest income on our municipal bonds purchased at a premium based on amortizing the premium to the earliest call date instead of amortizing the premium to maturity as prescribed pursuant to GAAP. These municipal bonds included bonds classified as available for sale and held to maturity. As a result, we determined the municipal bonds purchased at a premium should be re-amortized to maturity.
We evaluated the effect of this error and concluded that it was immaterial to any of the previously issued consolidated financial statements except for the unaudited consolidated financial statements included in our Quarterly Reports on Form 10-Q for the periods ended March 31, June 30, and September 30, 2013. Accordingly, on February 10, 2014, we filed a Form 8-K reporting that the Audit Committee of the Board of Directors of the Company determined based on the recommendation of management, that the Company should restate its unaudited consolidated financial statements in each of these Quarterly Reports on Form 10-Q. In addition, we will record in the fourth quarter of 2013 the immaterial cumulative effect of the error relating to prior years, which will increase net income by approximately $1.1 million for the year ended December 3l, 2013.
The aggregate net income resulting from the change in the amortization method for municipal securities purchased at a premium to maturity from the earliest call date for the second quarter of 2013 was $996,000, which should have been recorded during the second quarterly period of 2013.
The correction of the error resulted in an increase in net income of $996,000 and $1.5 million for the three and six months ended June 30, 2013, respectively, resulting in net income on a restated basis of $11.1 million and $20.1 million for those same periods.
A summary of the adjustments made and their effect on the financial statements is presented below (dollars in thousands):
 
 
As of June 30, 2013
Consolidated Balance Sheet
(unaudited)
 
As Originally Reported
 
Corrections
 
As Restated
 
 
 
 
 
 
 
Investment securities:
 
 
 
 
 
 
Held to maturity, at amortized cost (1)
 
$
302,775

 
$
219

 
$
302,994

Deferred tax asset (4)
 
20,883

 
595

 
21,478

Other assets (5)
 
51,511

 
(127
)
 
51,384

Total assets
 
3,384,978

 
687

 
3,385,665

 
 
 
 
 
 
 
Retained earnings (2)
 
65,219

 
1,513

 
66,732

Accumulated other comprehensive loss (3)
 
(30,162
)
 
(826
)
 
(30,988
)
Total shareholders’ equity
 
235,433

 
687

 
236,120

Total liabilities and shareholder's equity
 
3,384,978

 
687

 
3,385,665

“As Originally Reported” reflects balances reported in the June 30, 2013 Form 10-Q filed on August 7, 2013.
“Corrections” reflect changes to the originally reported balances and are described below.
“As Restated” reflects the final restated balances.
Balance Sheet Corrections:
(1)
The increase in investment securities held to maturity for the six months ended June 30, 2013 reflects the reduction in amortization expense that resulted in an increase in book value.
(2)
Retained earnings increased due to the decrease in amortization expense associated with amortizing our municipal securities purchased at a premium to the maturity of the security. The increase was partially offset by a reduction in the gain on the sale of available for sale municipal securities sold during the period due to the increase in book value of the securities sold during the six months ended June 30, 2013.
(3)
Accumulated other comprehensive loss increased as a result of an increase in the unrealized loss on the available for sale securities due to an increase in the book value of the municipal securities resulting from a decrease in amortization at June 30, 2013.
(4)
The correction to the deferred tax asset occurred as a result of recording the increase in the unrealized loss on available for sale securities for the municipal securities. In addition, deferred taxes changed as a result of the additional alternative minimum tax recorded as a result of recording the additional tax-exempt interest income.
(5)
The correction of other assets relates to a decrease in taxes receivable as a result of recording the additional alternative minimum tax.

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For the Three Months Ended
June 30, 2013
 
For the Six Months Ended
June 30, 2013
 
 
(in thousands)
 
(in thousands)
Consolidated Statement of Income
(unaudited)
 
As Originally Reported
 
Corrections
 
As Restated
 
As Originally Reported
 
Corrections
 
As Restated
 
 
 
 
 
 
 
 
 
 
 
 
 
Investment securities - tax-exempt (1)
 
$
4,877

 
$
1,030

 
$
5,907

 
$
8,835

 
$
1,560

 
$
10,395

Total interest income
 
28,185

 
1,030

 
29,215

 
54,216

 
1,560

 
55,776

Net interest income
 
23,841

 
1,030

 
24,871

 
44,771

 
1,560

 
46,331

Net interest income after provision for loan losses
 
21,820

 
1,030

 
22,850

 
42,258

 
1,560

 
43,818

Gain on sale of securities available for sale (2)
 
5,052

 
(51
)
 
5,001

 
9,417

 
(71
)
 
9,346

Total noninterest income
 
11,147

 
(51
)
 
11,096

 
21,407

 
(71
)
 
21,336

Income before income tax expense
 
11,801

 
979

 
12,780

 
22,180

 
1,489

 
23,669

Provision for income tax expense (3)
 
1,729

 
(17
)
 
1,712

 
3,583

 
(24
)
 
3,559

Net income
 
10,072

 
996

 
11,068

 
18,597

 
1,513

 
20,110

Earnings per common share – basic
 
0.56

 
0.06

 
0.62

 
1.04

 
0.09

 
$
1.13

Earnings per common share – diluted
 
0.56

 
0.06

 
0.62

 
1.04

 
0.08

 
$
1.12


“As Originally Reported” reflects balances reported in the June 30, 2013 Form 10-Q filed on August 7, 2013.
“Corrections” reflect changes to the originally reported balances and are described below.
“As Restated” reflects the final restated balances.
Income Statement Corrections:
(1)
The correction to investment securities - tax-exempt is a result of the reduction in tax-free amortization due to amortizing our municipal securities purchased at a premium to the maturity of the security.
(2)
The decrease in the gain on sale of securities available for sale is a result of the increase in book value on the municipal securities due to the decrease in amortization expense as a result of changing the amortization method to maturity from the earliest call date.
(3)
The change in provision for income tax expense is a direct result of the tax benefit associated with the decrease in the gain on sale of available for sale securities.

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As of and For the Three Months Ended
June 30, 2013
 
As of and For the Six Months Ended
June 30, 2013
 
 
(in thousands)
 
(in thousands)
Consolidated Statement of Comprehensive Income
(unaudited)
 
As Originally Reported
 
Corrections
 
As Restated
 
As Originally Reported
 
Corrections
 
As Restated
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
10,072

 
$
996

 
$
11,068

 
$
18,597

 
$
1,513

 
$
20,110

 
 
 
 
 
 
 
 
 
 
 
 
 
Unrealized holding losses on available for sale
securities during the period
 
(37,666
)
 
(870
)
 
(38,536
)
 
(42,881
)
 
(1,399
)
 
(44,280
)
Change in net unrealized gain on securities transferred to held to maturity
 
(30
)
 
58

 
28

 
(30
)
 
58

 
28

Reclassification adjustment for gain on sale of
available for sale securities included in net income
 
(5,052
)
 
51

 
(5,001
)
 
(9,417
)
 
71

 
(9,346
)
Other comprehensive loss, before tax
 
(42,008
)
 
(761
)
 
(42,769
)
 
(50,924
)
 
(1,270
)
 
(52,194
)
Income tax benefit related to other items of comprehensive income
 
14,703

 
266

 
14,969

 
17,824

 
444

 
18,268

Other comprehensive loss, net of tax
 
(27,305
)
 
(495
)
 
(27,800
)
 
(33,100
)
 
(826
)
 
(33,926
)
Comprehensive loss
 
(17,233
)
 
501

 
(16,732
)
 
(14,503
)
 
687

 
(13,816
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
As of and For the Six Months Ended
June 30, 2013
Consolidated Statement of Changes in Equity
 
 
 
 
 
 
(unaudited)
 
 
 
 
 
 
 
(in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
Retained earnings:
 
 
 
 
 
 
 
 
 
 
 
 
Net income
 
 
 
 
 
 
 
$
18,597

 
$
1,513

 
$
20,110

Balance, at June 30, 2013
 
 
 
 
 
 
 
65,219

 
1,513

 
66,732

 
 
 
 
 
 
 
 
 
 
 
 
 
Accumulated other comprehensive loss:
 
 
 
 
 
 
 
 
 
 
 
 
Other comprehensive loss
 
 
 
 
 
 
 
$
(33,100
)
 
$
(826
)
 
$
(33,926
)
Balance, at June 30, 2013
 
 
 
 
 
 
 
(30,162
)
 
(826
)
 
(30,988
)
Total shareholders' equity
 
 
 
 
 
 
 
235,433

 
687

 
236,120

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
As of and For the Six Months Ended
June 30, 2013
Consolidated Statement of Cash Flow
 
 
 
 
 
 
(unaudited)
 
 
 
 
 
 
 
(in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating Activities:
 
 
 
 
 
 
 
 
 
 
 
 
Net income
 
 
 
 
 
 
 
$
18,597

 
$
1,513

 
$
20,110

Amortization of premium
 
 
 
 
 
 
 
17,636

 
(1,621
)
 
16,015

Accretion of discount and loan fees
 
 
 
 
 
 
 
(2,913
)
 
61

 
(2,852
)
Deferred tax expense (benefit)
 
 
 
 
 
 
 
1,060

 
(151
)
 
909

Gain on sale of securities available for sale
 
 
 
 
 
 
 
(9,417
)
 
71

 
(9,346
)
Other assets
 
 
 
 
 
 
 
(7,117
)
 
127

 
(6,990
)
“As Originally Reported” reflects balances reported in the June 30, 2013 Form 10-Q filed on August 7, 2013.
“Corrections” reflect changes to the originally reported balances.
“As Restated” reflects the final restated balances.

10

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3.    Earnings Per Share - (2013 Restated)

Earnings per share on a basic and diluted basis have been adjusted to give retroactive recognition to stock dividends and is calculated as follows (in thousands, except per share amounts):
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2013
 
2012
 
2013
 
2012
Basic and Diluted Earnings:
 
 
 
 
 
 
 
Net income
$
11,068

 
$
7,729

 
$
20,110

 
$
17,868

Basic weighted-average shares outstanding
17,849

 
18,210

 
17,853

 
18,203

Add:   Stock options
32

 
13

 
26

 
13

Diluted weighted-average shares outstanding
17,881

 
18,223

 
17,879

 
18,216

 
 

 
 

 
 

 
 

Basic Earnings Per Share:
$
0.62

 
$
0.42

 
$
1.13

 
$
0.98

 
 

 
 

 
 

 
 

Diluted Earnings Per Share:
$
0.62

 
$
0.42

 
$
1.12

 
$
0.98


For the three- and six-month periods ended June 30, 2013 there were approximately 10,000 and 17,000 anti-dilutive shares, respectively. For the three- and six-month periods ended June 30, 2012 there were approximately 4,000 and 6,000 anti-dilutive shares, respectively.

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4.     Accumulated Other Comprehensive (Loss) Income - (2013 Restated)

The changes in accumulated other comprehensive income by component are as follows (in thousands):

 
Six Months Ended June 30, 2013
 
Unrealized Gains (Losses) on Securities
 
Pension Plans
 
 
 
Other
 
OTTI
 
Net Prior
 Service
 (Cost)
 Credit
 
Net Gain (Loss)
 
Total
Beginning balance, net of tax
$
30,500

 
$
(1,140
)
 
$
248

 
$
(26,670
)
 
$
2,938

Other comprehensive (loss) income before reclassifications
(44,416
)
 
154

 

 

 
(44,262
)
Reclassified from accumulated other comprehensive income
(9,346
)
 
42

 
(22
)
 
1,394

 
(7,932
)
Income tax benefit (expense)
18,816

 
(68
)
 
8

 
(488
)
 
18,268

Net current-period other comprehensive (loss) income, net of tax
(34,946
)
 
128

 
(14
)
 
906

 
(33,926
)
Ending balance, net of tax
$
(4,446
)
 
$
(1,012
)
 
$
234

 
$
(25,764
)
 
$
(30,988
)

 
Three Months Ended June 30, 2013
 
Unrealized Gains (Losses) on Securities
 
Pension Plans
 
 
 
Other
 
OTTI
 
Net Prior
 Service
 (Cost)
 Credit
 
Net Gain (Loss)
 
Total
Beginning balance, net of tax
$
24,194

 
$
(1,371
)
 
$
241

 
$
(26,252
)
 
$
(3,188
)
Other comprehensive (loss) income before reclassifications
(39,060
)
 
552

 

 

 
(38,508
)
Reclassified from accumulated other comprehensive income
(5,001
)
 

 
(11
)
 
751

 
(4,261
)
Income tax benefit (expense)
15,421

 
(193
)
 
4

 
(263
)
 
14,969

Net current-period other comprehensive (loss) income, net of tax
(28,640
)
 
359

 
(7
)
 
488

 
(27,800
)
Ending balance, net of tax
$
(4,446
)
 
$
(1,012
)
 
$
234

 
$
(25,764
)
 
$
(30,988
)



12

Table of Contents


 
Six Months Ended June 30, 2012
 
Unrealized Gains (Losses) on Securities
 
Pension Plans
 
 
 
Other
 
OTTI
 
Net Prior
 Service
 (Cost)
 Credit
 
Net Gain (Loss)
 
Total
Beginning balance, net of tax
$
37,271

 
$
(1,577
)
 
$
276

 
$
(21,249
)
 
$
14,721

Other comprehensive (loss) income before reclassifications
(3,987
)
 
124

 

 

 
(3,863
)
Reclassified from accumulated other comprehensive income
(9,269
)
 
181

 
(22
)
 
1,011

 
(8,099
)
Income tax benefit (expense)
4,640

 
(107
)
 
8

 
(354
)
 
4,187

Net current-period other comprehensive (loss) income, net of tax
(8,616
)
 
198

 
(14
)
 
657

 
(7,775
)
Ending balance, net of tax
$
28,655

 
$
(1,379
)
 
$
262

 
$
(20,592
)
 
$
6,946


 
Three Months Ended June 30, 2012
 
Unrealized Gains (Losses) on Securities
 
Pension Plans
 
 
 
Other
 
OTTI
 
Net Prior
 Service
 (Cost)
 Credit
 
Net Gain (Loss)
 
Total
Beginning balance, net of tax
$
30,202

 
$
(1,382
)
 
$
270

 
$
(20,925
)
 
$
8,165

Other comprehensive (loss) income before reclassifications
917

 
(35
)
 

 

 
882

Reclassified from accumulated other comprehensive income
(3,297
)
 
40

 
(12
)
 
512

 
(2,757
)
Income tax benefit (expense)
833

 
(2
)
 
4

 
(179
)
 
656

Net current-period other comprehensive (loss) income, net of tax
(1,547
)
 
3


(8
)
 
333

 
(1,219
)
Ending balance, net of tax
$
28,655

 
$
(1,379
)
 
$
262


$
(20,592
)
 
$
6,946



13

Table of Contents


The reclassifications out of accumulated other comprehensive income into net income are presented below (in thousands):

 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2013
 
2012
 
2013
 
2012
Unrealized gains on available-for-sale securities:
 
 
 
 
 
 
 
Realized gain on sale of securities (1)
$
5,001

 
$
3,297

 
$
9,346

 
$
9,269

Impairment losses (2)

 
(40
)
 
(42
)
 
(181
)
Total before tax
5,001

 
3,257

 
9,304

 
9,088

Tax benefit (expense)
(1,750
)
 
(1,140
)
 
(3,256
)
 
(3,181
)
Net of tax
$
3,251

 
$
2,117

 
$
6,048

 
$
5,907

 
 
 
 
 
 
 
 
Amortization of defined benefit pension items:
 
 
 
 
 
 
 
Net loss (3)
$
(751
)
 
$
(512
)
 
$
(1,394
)
 
$
(1,011
)
Prior service credit (3)
11

 
12

 
22

 
22

Total before tax
(740
)
 
(500
)
 
(1,372
)
 
(989
)
Tax benefit (expense)
259

 
175

 
480

 
346

Net of tax
$
(481
)
 
$
(325
)
 
$
(892
)
 
$
(643
)
Total reclassifications for the period, net of tax
$
2,770

 
$
1,792

 
$
5,156

 
$
5,264


(1) Listed as Gain on sale of securities available for sale on the Statements of Income.
(2) Listed as Net impairment losses recognized in earnings on the Statements of Income.
(3) These accumulated other comprehensive income components are included in the computation of net periodic pension cost presented in “Note 8 - Employee Benefit Plans.”

5.     Securities - (2013 Restated)

The amortized cost and estimated fair value of investment and mortgage-backed securities as of June 30, 2013 and December 31, 2012, are reflected in the tables below (in thousands):
 
 
June 30, 2013
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
AVAILABLE FOR SALE
 
 
OTTI
 
Other
 
Investment Securities:
 
 
 
 
 
 
 
 
 
U.S. Government Agency Debentures
$
15,551

 
$

 
$

 
$
1,353

 
$
14,198

State and Political Subdivisions
473,295

 
7,118

 

 
20,586

 
459,827

Other Stocks and Bonds
15,770

 
142

 
1,558

 
58

 
14,296

Mortgage-backed Securities: (1)
 

 
 

 
 

 
 

 
 

Residential
670,639

 
15,402

 

 
2,420

 
683,621

Commercial
146,289

 
274

 

 
8,424

 
138,139

Total
$
1,321,544

 
$
22,936

 
$
1,558

 
$
32,841

 
$
1,310,081

 
 
June 30, 2013
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
HELD TO MATURITY
 
 
OTTI
 
Other
 
Investment Securities:
 
 
 
 
 
 
 
 
 
State and Political Subdivisions
$
302,994

 
$
110

 
$

 
$
12,871

 
$
290,233

Mortgage-backed Securities: (1)
 

 
 

 
 

 
 

 
 

Residential
125,189

 
5,134

 

 
1

 
130,322

Commercial
115,325

 

 

 
5,786

 
109,539

Total
$
543,508

 
$
5,244

 
$

 
$
18,658

 
$
530,094


 
 
December 31, 2012
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
AVAILABLE FOR SALE
 
 
OTTI
 
Other
 
Investment Securities:
 
 
 
 
 
 
 
 
 
U.S. Government Agency Debentures
$
61,461

 
$

 
$

 
$
598

 
$
60,863

State and Political Subdivisions
515,116

 
30,888

 

 
316

 
545,688

Other Stocks and Bonds
12,807

 
104

 
1,754

 
1

 
11,156

Mortgage-backed Securities: (1)
 

 
 

 
 

 
 

 
 

Residential
789,356

 
18,003

 

 
999

 
806,360

Total
$
1,378,740

 
$
48,995

 
$
1,754

 
$
1,914

 
$
1,424,067


 
 
December 31, 2012
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
HELD TO MATURITY
 
 
OTTI
 
Other
 
Investment Securities:
 
 
 
 
 
 
 
 
 
State and Political Subdivisions
$
1,009

 
$
128

 
$

 
$

 
$
1,137

Mortgage-backed Securities: (1)
 

 
 

 
 

 
 

 
 

Residential
245,538

 
8,770

 

 
47

 
254,261

Total
$
246,547

 
$
8,898

 
$

 
$
47

 
$
255,398


(1) All mortgage-backed securities issued and/or guaranteed by U.S. government agencies or U.S. government-sponsored enterprises.

Securities carried at fair value through income were as follows (in thousands):

 
At
June 30,
 
At
December 31,
 
At
December 31,
 
2013
 
2012
 
2011
Mortgage-backed Securities:
 
 
 
 
 
U.S. Government Agencies
$

 
$

 
$
30,413

Government-Sponsored Enterprises

 

 
617,346

Total
$

 
$

 
$
647,759


14

Table of Contents



Net gains and losses on securities carried at fair value through income were as follows (in thousands):

 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2013
 
2012
 
2013
 
2012
Net (loss) gain on sales transactions
$

 
$
(13
)
 
$

 
$
(498
)
Net mark-to-market gains

 

 

 

Net (loss) gain on securities carried at fair value through income
$

 
$
(13
)
 
$

 
$
(498
)



15

Table of Contents



The following table represents the unrealized loss on securities for the six months ended June 30, 2013 and year ended December 31, 2012 (in thousands):
 
As of June 30, 2013
 
Less Than 12 Months
 
More Than 12 Months
 
Total
 
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
AVAILABLE FOR SALE
 
 
 
 
 
 
 
 
 
 
 
Investment Securities:
 
 
 
 
 
 
 
 
 
 
 
U.S. Government Agency Debentures
$
14,198

 
$
1,353

 
$

 
$

 
$
14,198

 
$
1,353

State and Political Subdivisions
341,507

 
20,586

 

 

 
341,507

 
20,586

Other Stocks and Bonds
5,272

 
58

 
1,144

 
1,558

 
6,416

 
1,616

Mortgage-backed Securities:
 
 
 
 
 
 
 
 
 
 
 
Residential
115,495

 
1,967

 
28,072

 
453

 
143,567

 
2,420

Commercial
135,287

 
8,424

 

 

 
135,287

 
8,424

Total
$
611,759

 
$
32,388

 
$
29,216

 
$
2,011

 
$
640,975

 
$
34,399

HELD TO MATURITY
 

 
 

 
 

 
 

 
 

 
 

Investment Securities:
 
 
 
 
 
 
 
 
 
 
 
State and Political Subdivisions
$
287,987

 
$
12,871

 
$

 
$

 
$
287,987

 
$
12,871

Mortgage-backed Securities:
 
 
 
 
 
 
 
 
 
 
 
Residential
3,074

 
1

 

 

 
3,074

 
1

Commercial
109,539

 
5,786

 

 

 
109,539

 
5,786

Total
$
400,600

 
$
18,658

 
$

 
$

 
$
400,600

 
$
18,658

 
 
 
 
 
 
 
 
 
 
 
 
 
As of December 31, 2012
 
Less Than 12 Months
 
More Than 12 Months
 
Total
 
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
AVAILABLE FOR SALE
 

 
 

 
 

 
 

 
 

 
 

Investment Securities:
 
 
 
 
 
 
 
 
 
 
 
U.S. Government Agency Debentures
$
60,863

 
$
598

 
$

 
$

 
$
60,863

 
$
598

State and Political Subdivisions
49,548

 
316

 

 

 
49,548

 
316

Other Stocks and Bonds
4,856

 
1

 
990

 
1,754

 
5,846

 
1,755

Mortgage-backed Securities:
 
 
 
 
 
 
 
 
 
 
 
Residential
260,909

 
967

 
3,122

 
32

 
264,031

 
999

Total
$
376,176

 
$
1,882

 
$
4,112

 
$
1,786

 
$
380,288

 
$
3,668

HELD TO MATURITY
 

 
 

 
 

 
 

 
 

 
 

Mortgage-backed Securities:
 
 
 
 
 
 
 
 
 
 
 
Residential
$
3,251

 
$
47

 
$

 
$

 
$
3,251

 
$
47

Total
$
3,251

 
$
47

 
$

 
$

 
$
3,251

 
$
47


When it is determined that a decline in fair value of Held to Maturity (“HTM”) and Available for Sale (“AFS”) securities are other-than-temporary, the carrying value of the security is reduced to its estimated fair value, with a corresponding charge to earnings for the credit portion and to other comprehensive income for the noncredit portion.  In estimating other-than-temporary impairment losses, management considers, among other things, (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer and (3) whether we have a current intent to sell the security

16

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and whether it is not more likely than not that we will be required to sell the security before the anticipated recovery of their amortized cost basis.

At June 30, 2013, we have in AFS Other Stocks and Bonds, $2.7 million amortized cost basis in pooled trust preferred securities (“TRUPs”).  Those securities are structured products with cash flows dependent upon securities issued by U.S. financial institutions, including banks and insurance companies.  Our estimate of fair value at June 30, 2013 for the TRUPs is approximately $1.1 million and reflects the market illiquidity.  With the exception of the TRUPs, to the best of management’s knowledge and based on our consideration of the qualitative factors associated with each security, there were no securities in our investment and mortgage-backed securities portfolio at June 30, 2013 with an other-than-temporary impairment.

Given the facts and circumstances associated with the TRUPs we performed detailed cash flow modeling for each TRUP using an industry-accepted cash flow model.  Prior to loading the required assumptions into the model we reviewed the financial condition of each of the underlying issuing banks within the TRUP collateral pool that had not deferred or defaulted as of June 30, 2013.  Management’s best estimate of a deferral assumption was assigned to each issuing bank based on the category in which it fell.  Our analysis of the underlying cash flows contemplated various default, deferral and recovery scenarios to arrive at our best estimate of cash flows.  Based on that detailed analysis, we have concluded that the other-than-temporary impairment, which captures the credit component, was estimated at $3.3 million at June 30, 2013 and December 31, 2012. The noncredit charge to other comprehensive income was estimated at $1.6 million and $1.8 million at June 30, 2013 and December 31, 2012, respectively.  The carrying amount of the TRUPs was written down with $75,000 and $3.0 million recognized in earnings for the years ended December 31, 2010 and 2009, respectively.  There was no write-down recognized in earnings during 2011 but there was an additional write-down of the TRUPs recognized in earnings in the amount of approximately $181,000 during 2012. For the six months ended June 30, 2013 and 2012, the additional write-down recognized in earnings was approximately $42,000 and $181,000, respectively. The cash flow model assumptions represent management’s best estimate and consider a variety of qualitative factors, which include, among others, the credit rating downgrades, the severity and duration of the mark-to-market loss, and the structural nuances of each TRUP. We will continue to update our assumptions and the resulting analysis each reporting period to reflect changing market conditions.  Additionally, we do not currently intend to sell the TRUPs and it is not more likely than not that we will be required to sell the TRUPs before the anticipated recovery of their amortized cost basis.

The table below provides more detail on the TRUPs at June 30, 2013 (in thousands):

TRUP
 
Par
 
Credit
Loss
 
Amortized
Cost
 
Fair
Value
 
Tranche
 
Credit
Rating
1
 
$
2,000

 
$
1,298

 
$
702

 
$
26

 
C1
 
Ca
2
 
2,000

 
550

 
1,450

 
733

 
B1
 
C
3
 
2,000

 
1,450

 
550

 
385

 
B2
 
C
 
 
$
6,000

 
$
3,298

 
$
2,702

 
$
1,144

 
 
 
 

The following tables present a roll forward of the credit losses recognized in earnings, on AFS debt securities
(in thousands):
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2013
 
2012
 
2013
 
2012
Balance, beginning of period
$
3,298

 
$
3,216

 
$
3,256

 
$
3,075

Additions for credit losses recognized on debt securities that had previously incurred impairment losses

 
40

 
42

 
181

Balance, end of period
$
3,298

 
$
3,256

 
$
3,298

 
$
3,256


Interest income recognized on securities for the periods presented (in thousands):

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Six Months Ended
June 30,
 
2013
 
2012
U.S. Treasury
$
17

 
$

U.S. Government Agency Debentures
305

 

State and Political Subdivisions
10,507

 
5,642

Other Stocks and Bonds
99

 
37

Mortgage-backed Securities
8,616

 
21,035

Total interest income on securities
$
19,544

 
$
26,714


 
Three Months Ended
June 30,
 
2013
 
2012
U.S. Treasury
$

 
$

U.S. Government Agency Debentures
93

 

State and Political Subdivisions
5,929

 
2,968

Other Stocks and Bonds
54

 
13

Mortgage-backed Securities
4,680

 
8,872

Total interest income on securities
$
10,756

 
$
11,853


During the second quarter of 2013, the Company transferred commercial mortgage-backed securities with a fair value of $57.9 million and state and political subdivisions securities with a fair value of $232.2 million from AFS to HTM due to overall balance sheet strategies. The unrealized gain on the securities transferred from AFS to HTM was $3.2 million ($2.1 million, net of tax) at the date of transfer based on the fair value of the securities on the transfer date. The unrealized gain on the transferred securities included in accumulated other comprehensive income will be amortized over the remaining life of the underlying security as an adjustment of the yield on those securities. There were no sales from the HTM portfolio during the six months ended June 30, 2013 or 2012.  There were $543.5 million and $246.5 million of securities classified as HTM at June 30, 2013 and December 31, 2012, respectively.

Of the $9.3 million in net securities gains from the AFS portfolio for the six months ended June 30, 2013, there were $10.7 million in realized gains and approximately $1.4 million in realized losses.  Of the $9.3 million in net securities gains from the AFS portfolio for the six months ended June 30, 2012, there were $9.4 million in realized gains and approximately $105,000 in realized losses.

The amortized cost and fair value of securities at June 30, 2013, are presented below by contractual maturity.  Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations.  Mortgage-backed securities are presented in total by category due to the fact that mortgage-backed securities typically are issued with stated principal amounts, and the securities are backed by pools of mortgages that have loans with varying maturities.  The characteristics of the underlying pool of mortgages, such as fixed-rate or adjustable-rate, as well as prepayment risk, are passed on to the security holder.  The term of a mortgage-backed pass-through security thus approximates the term of the underlying mortgages and can vary significantly due to prepayments.

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June 30, 2013
 
Amortized Cost
 
Fair Value
AVAILABLE FOR SALE
(in thousands)
Investment Securities:
 
 
 
Due in one year or less
$
2,788

 
$
2,793

Due after one year through five years
23,755

 
24,172

Due after five years through ten years
56,024

 
56,397

Due after ten years
422,049

 
404,959

 
504,616

 
488,321

Mortgage-backed Securities:
816,928

 
821,760

Total
$
1,321,544

 
$
1,310,081


 
June 30, 2013
 
Amortized Cost
 
Fair Value
HELD TO MATURITY
(in thousands)
Investment Securities:
 
 
 
Due in one year or less
$

 
$

Due after one year through five years
218

 
215

Due after five years through ten years
8,797

 
8,572

Due after ten years
293,979

 
281,446

 
302,994

 
290,233

Mortgage-backed Securities:
240,514

 
239,861

Total
$
543,508

 
$
530,094


Investment and mortgage-backed securities with book values of $912.1 million and $945.7 million were pledged as of June 30, 2013 and December 31, 2012, respectively, to collateralize Federal Home Loan Bank (“FHLB”) advances, repurchase agreements, and public funds or for other purposes as required by law.

Securities with limited marketability, such as FHLB stock and other investments, are carried at cost, which approximates its fair value and are assessed for other-than-temporary impairment.  These securities have no maturity date.

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6.     Loans and Allowance for Probable Loan Losses

Loans in the accompanying consolidated balance sheets are classified as follows (in thousands):

 
June 30, 2013
 
December 31, 2012
Real Estate Loans:
 
 
 
Construction
$
123,493

 
$
113,744

1-4 Family residential
385,241

 
368,845

Other
232,632

 
236,760

Commercial loans
153,985

 
160,058

Municipal loans
224,134

 
220,947

Loans to individuals
173,944

 
162,623

Total loans
1,293,429

 
1,262,977

Less: Allowance for loan losses
18,370

 
20,585

Net loans
$
1,275,059

 
$
1,242,392


Allowance for Loan Losses

The allowance for loan losses is based on the most current review of the loan portfolio and is validated by multiple processes.  First, the bank utilizes historical data to establish general reserve amounts for each class of loans.  An average three-year history of annualized net charge-offs against the average portfolio balance for that time period is utilized. The historical charge-off figure is further adjusted through qualitative factors that include general trends in past dues, nonaccruals and classified loans to more effectively and promptly react to both positive and negative movements. Second, our lenders have the primary responsibility for identifying problem loans and estimating necessary reserves based on customer financial stress and underlying collateral.  These recommendations are reviewed by the senior lender, the Special Assets department, and the Loan Review department.  Third, the Loan Review department does independent reviews of the portfolio on an annual basis.  The Loan Review department follows a board-approved annual loan review scope.  The loan review scope encompasses a number of metrics that takes into consideration the size of the loan, the type of credit extended, the seasoning of the loan along with the performance of the loan.  The loan review scope, as it relates to size, focuses more on larger dollar loan relationships, typically, for example, aggregate debt of $500,000 or greater.  The loan review officer also tracks specific reserves for loans by type compared to general reserves to determine trends in comparative reserves as well as losses not reserved for prior to charge-off to determine the effectiveness of the specific reserve process.

At each review, a subjective analysis methodology is used to grade the respective loan.  Categories of grading vary in severity from loans that do not appear to have a significant probability of loss at the time of review to loans that indicate a probability that the entire balance of the loan will be uncollectible.  If full collection of the loan balance appears unlikely at the time of review, estimates of future expected cash flows or appraisals of the collateral securing the debt are used to determine the necessary allowances.  The internal loan review department maintains a list of all loans or loan relationships that are graded as having more than the normal degree of risk associated with them.  In addition, a list of specifically reserved loans or loan relationships of $50,000 or more is updated on a quarterly basis in order to properly determine necessary allowances and keep management informed on the status of attempts to correct the deficiencies noted with respect to the loan.

For loans to individuals, the methodology associated with determining the appropriate allowance for losses on loans primarily consists of an evaluation of individual payment histories, remaining term to maturity and underlying collateral support.

Industry and our own experience indicates that a portion of our loans will become delinquent and a portion of the loans will require partial or full charge-off.  Regardless of the underwriting criteria utilized, losses may be experienced as a result of various factors beyond our control, including, among other things, changes in market conditions affecting the value of properties used as collateral for loans and problems affecting the credit of the borrower and the ability of the borrower to make payments on the loan.  Our determination of the appropriateness of the allowance for loan losses is based on various considerations, including an analysis of the risk characteristics of various classifications of loans, previous loan loss experience, specific loans which would have loan loss potential, delinquency trends, estimated fair value of the underlying collateral, current economic conditions, the views of the

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bank regulators (who have the authority to require additional allowances in accordance with GAAP), and geographic and industry loan concentration.

Consumer loans at SFG are reserved for based on general estimates of loss at the time of purchase for current loans.  SFG loans experiencing past due status or extension of maturity characteristics are reserved for at significantly higher levels based on the circumstances associated with each specific loan.  In general the reserves for SFG are calculated based on the past due status of the loan.  For reserve purposes, the portfolio has been segregated by past due status and by the remaining term variance from the original contract.  During repayment, loans that pay late will take longer to pay out than the original contract.  Additionally, some loans may be granted extensions for extenuating payment circumstances and evaluated for troubled debt classification.  The remaining term extensions increase the risk of collateral deterioration and, accordingly, reserves are increased to recognize this risk.

New pools purchased are reserved at their estimated annual loss. Additionally, we use data mining measures to track migration within risk tranches.  Reserves are adjusted quarterly to match the migration metrics.

Credit Quality Indicators

We categorize loans into risk categories on an ongoing basis based on relevant information about the ability of borrowers to service their debt such as:  current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors.  We use the following definitions for risk ratings:

Satisfactory (Rating 1 – 4) – This rating is assigned to all satisfactory loans.  This category, by definition, should consist of acceptable credit.  Credit and collateral exceptions should not be present, although their presence would not necessarily prohibit a loan from being rated Satisfactory, if deficiencies are in process of correction.  These loans will not be included in the Watch List.

Satisfactory (Rating 5) – Special Treatment Required – (Pass Watch) – These loans require some degree of special treatment, but not due to credit quality.  This category does not include loans specially mentioned or adversely classified by the Loan Review Officer or regulatory authorities; however, particular attention must be accorded such credits due to characteristics such as:

A lack of, or abnormally extended payment program;
A heavy degree of concentration of collateral without sufficient margin;
A vulnerability to competition through lesser or extensive financial leverage; and
A dependence on a single, or few customers, or sources of supply and materials without suitable substitutes or alternatives.

Special Mention (Rating 6) – A Special Mention asset has potential weaknesses that deserve management’s close attention.  If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution’s credit position at some future date.  Special Mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.

Substandard (Rating 7) – Substandard loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any.  Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt.  They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

Doubtful (Rating 8) – Loans classified as Doubtful have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses make collection or liquidation, in full, on the basis of currently known facts, conditions and values, highly questionable and improbable.

Loss (Rating 9) – Loans classified as Loss are currently in the process of being charged off and are fully reserved. They are considered uncollectible and of such little value that their continuance as bankable assets is not warranted.

Loans that are accruing and not considered troubled debt restructurings ("TDR") are reserved for as a group of similar type credits and included in the general portion of the allowance for loan losses.


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Table of Contents


The general portion of the loan loss allowance is reflective of historical charge-off levels for similar loans adjusted for changes in current conditions and other relevant factors.  These factors are likely to cause estimated losses to differ from historical loss experience and include:

Changes in lending policies or procedures, including underwriting, collection, charge-off, and recovery procedures;
Changes in local, regional and national economic and business conditions including entry into new markets;
Changes in the volume or type of credit extended;
Changes in the experience, ability, and depth of lending management;
Changes in the volume and severity of past due, nonaccrual, restructured, or classified loans;
Changes in loan review or Board oversight;
Changes in the level of concentrations of credit; and
Changes in external factors, such as competition and legal and regulatory requirements.

The following tables detail activity in the allowance for loan losses by portfolio segment for the periods presented (in thousands):
 
 
Six Months Ended June 30, 2013
 
Real Estate
 
 
 
 
 
 
 
 
 
 
 
Construction
 
1-4 Family
Residential
 
Other
 
Commercial
Loans
 
Municipal
Loans
 
Loans to
Individuals
 
Unallocated
 
Total
Balance at beginning of period
$
2,355

 
$
3,545

 
$
2,290

 
$
3,158

 
$
633

 
$
7,373

 
$
1,231

 
$
20,585

Provision (reversal) for loan losses
(277
)
 
281

 
(129
)
 
(620
)
 

 
3,916

 
(658
)
 
2,513

Loans charged off

 
(228
)
 
(67
)
 
(198
)
 

 
(5,364
)
 

 
(5,857
)
Recoveries of loans charged off
22

 
11

 
10

 
110

 

 
976

 

 
1,129

Balance at end of period
$
2,100

 
$
3,609

 
$
2,104

 
$
2,450

 
$
633

 
$
6,901

 
$
573

 
$
18,370


 
Three Months Ended June 30, 2013
 
Real Estate
 
 
 
 
 
 
 
 
 
 
 
Construction
 
1-4 Family
Residential
 
Other
 
Commercial
Loans
 
Municipal
Loans
 
Loans to
Individuals
 
Unallocated
 
Total
Balance at beginning of period
$
2,247

 
$
3,488

 
$
2,002

 
$
2,847

 
$
621

 
$
6,451

 
$
886

 
$
18,542

Provision (reversal) for loan losses
(152
)
 
114

 
118

 
(330
)
 
12

 
2,572

 
(313
)
 
2,021

Loans charged off

 

 
(21
)
 
(127
)
 

 
(2,557
)
 

 
(2,705
)
Recoveries of loans charged off
5

 
7

 
5

 
60

 

 
435

 

 
512

Balance at end of period
$
2,100

 
$
3,609

 
$
2,104

 
$
2,450

 
$
633

 
$
6,901

 
$
573

 
$
18,370


 
Six Months Ended June 30, 2012
 
Real Estate
 
 
 
 
 
 
 
 
 
 
 
Construction
 
1-4 Family
Residential
 
Other
 
Commercial
Loans
 
Municipal
Loans
 
Loans to
Individuals
 
Unallocated
 
Total
Balance at beginning of period
$
2,620

 
$
1,957

 
$
3,051

 
$
2,877

 
$
619

 
$
6,244

 
$
1,172

 
$
18,540

Provision (reversal) for loan losses
(178
)
 
396

 
177

 
433

 
12

 
4,419

 
(33
)
 
5,226

Loans charged off
(15
)
 
(53
)
 
(93
)
 
(375
)
 

 
(4,466
)
 

 
(5,002
)
Recoveries of loans charged off
47

 
160

 
3

 
253

 

 
967

 

 
1,430

Balance at end of period
$
2,474

 
$
2,460

 
$
3,138

 
$
3,188

 
$
631

 
$
7,164

 
$
1,139

 
$
20,194


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Table of Contents


 
Three Months Ended June 30, 2012
 
Real Estate
 
 
 
 
 
 
 
 
 
 
 
Construction
 
1-4 Family
Residential
 
Other
 
Commercial
Loans
 
Municipal
Loans
 
Loans to
Individuals
 
Unallocated
 
Total
Balance at beginning of period
$
2,682

 
$
2,290

 
$
3,065

 
$
3,342

 
$
608

 
$
6,918

 
$
1,169

 
$
20,074

Provision (reversal) for loan losses
(227
)
 
57

 
165

 
78

 
23

 
2,108

 
(30
)
 
2,174

Loans charged off
(7
)
 
(42
)
 
(93
)
 
(287
)
 

 
(2,343
)
 

 
(2,772
)
Recoveries of loans charged off
26

 
155

 
1

 
55

 

 
481

 

 
718

Balance at end of period
$
2,474

 
$
2,460

 
$
3,138

 
$
3,188

 
$
631

 
$
7,164

 
$
1,139

 
$
20,194


The following tables present the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based on impairment method as described in the allowance for loan losses methodology discussion (in thousands):

 
As of June 30, 2013
 
Real Estate
 
 
 
 
 
 
 
 
 
 
 
Construction
 
1-4 Family
Residential
 
Other
 
Commercial
Loans
 
Municipal
Loans
 
Loans to
Individuals
 
Unallocated
 
Total
Ending balance – individually evaluated for impairment
$
83

 
$
235

 
$
77

 
$
435

 
$

 
$
160

 
$

 
$
990

Ending balance – collectively evaluated for impairment
2,017

 
3,374

 
2,027

 
2,015

 
633

 
6,741

 
573

 
17,380

Balance at end of period
$
2,100

 
$
3,609

 
$
2,104

 
$
2,450

 
$
633

 
$
6,901

 
$
573

 
$
18,370


 
As of December 31, 2012
 
Real Estate
 
 
 
 
 
 
 
 
 
 
 
Construction
 
1-4 Family
Residential
 
Other
 
Commercial
Loans
 
Municipal
Loans
 
Loans to
Individuals
 
Unallocated
 
Total
Ending balance – individually evaluated for impairment
$
200

 
$
222

 
$
243

 
$
631

 
$

 
$
175

 
$

 
$
1,471

Ending balance – collectively evaluated for impairment
2,155

 
3,323

 
2,047

 
2,527

 
633

 
7,198

 
1,231

 
19,114

Balance at end of period
$
2,355

 
$
3,545

 
$
2,290

 
$
3,158

 
$
633

 
$
7,373

 
$
1,231

 
$
20,585

 
The following table details activity of the reserve for unfunded loan commitments for the periods presented (in thousands):

 
Six Months Ended
June 30,
 
2013
 
2012
Reserve For Unfunded Loan Commitments:
 
 
 
Balance at beginning of period
$
5

 
$
26

Provision (reversal) for losses on unfunded loan commitments
7

 
(23
)
Balance at end of period
$
12

 
$
3



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Table of Contents


 
Three Months Ended
June 30,
 
2013
 
2012
Reserve For Unfunded Loan Commitments:
 
 
 
Balance at beginning of period
$
5

 
$
26

Provision (reversal) for losses on unfunded loan commitments
7

 
(23
)
Balance at end of period
$
12

 
$
3


The following table sets forth the balance in the recorded investment in loans by portfolio segment based on impairment method as described in the allowance for loan losses methodology discussion for the periods presented (in thousands):

 
June 30, 2013
 
Real Estate
 
 
 
 
 
 
 
 
 
Construction
 
1-4 Family
Residential
 
Other
 
Commercial
Loans
 
Municipal
Loans
 
Loans to
Individuals
 
Total
Loans individually evaluated for impairment
$
1,581

 
$
3,062

 
$
1,879

 
$
1,834

 
$

 
$
526

 
$
8,882

Loans collectively evaluated for impairment
121,912

 
382,179

 
230,753

 
152,151

 
224,134

 
173,418

 
1,284,547

Total ending loan balance
$
123,493

 
$
385,241

 
$
232,632

 
$
153,985

 
$
224,134

 
$
173,944

 
$
1,293,429


 
December 31, 2012
 
Real Estate
 
 
 
 
 
 
 
 
 
Construction
 
1-4 Family
Residential
 
Other
 
Commercial
Loans
 
Municipal
Loans
 
Loans to
Individuals
 
Total
Loans individually evaluated for impairment
$
2,465

 
$
2,799

 
$
2,613

 
$
2,043

 
$

 
$
594

 
$
10,514

Loans collectively evaluated for impairment
111,279

 
366,046

 
234,147

 
158,015

 
220,947

 
162,029

 
1,252,463

Total ending loan balance
$
113,744

 
$
368,845

 
$
236,760

 
$
160,058

 
$
220,947

 
$
162,623

 
$
1,262,977


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The following table sets forth loans by credit quality indicator for the periods presented (in thousands):

 
June 30, 2013
 
Pass
 
Pass Watch
 
Special Mention
 
Substandard
 
Doubtful
 
Loss
 
Total
Real Estate Loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction
$
116,891

 
$

 
$
3,580

 
$
2,952

 
$
70

 
$

 
$
123,493

1-4 Family residential
376,024

 
1,660

 
1,466

 
5,262

 
829

 

 
385,241

Other
218,362

 
2,619

 
4,959

 
6,658

 
34

 

 
232,632

Commercial loans
145,766

 
874

 
11

 
6,746

 
588

 

 
153,985

Municipal loans
223,813

 

 

 
321

 

 

 
224,134

Loans to individuals
172,875

 
53

 
3

 
683

 
330

 

 
173,944

Total
$
1,253,731

 
$
5,206

 
$
10,019

 
$
22,622

 
$
1,851

 
$

 
$
1,293,429


 
December 31, 2012
 
Pass
 
Pass Watch
 
Special Mention
 
Substandard
 
Doubtful
 
Loss
 
Total
Real Estate Loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction
$
106,091

 
$

 
$
3,637

 
$
3,941

 
$
75

 
$

 
$
113,744

1-4 Family residential
360,282

 
1,805

 
170

 
5,711

 
877

 

 
368,845

Other
226,394

 
2,721

 
4,073

 
3,319

 
253

 

 
236,760

Commercial loans
153,774

 
731

 

 
4,690

 
863

 

 
160,058

Municipal loans
220,388

 
204

 

 
355

 

 

 
220,947

Loans to individuals
161,458

 
27

 
4

 
723

 
393

 
18

 
162,623

Total
$
1,228,387

 
$
5,488

 
$
7,884

 
$
18,739

 
$
2,461

 
$
18

 
$
1,262,977


The following table sets forth nonperforming assets for the periods presented (in thousands):

 
At
June 30,
2013
 
At
December 31,
2012
Nonaccrual loans
$
8,179

 
$
10,314

Accruing loans past due more than 90 days

 
15

Restructured loans
3,053

 
2,998

Other real estate owned
772

 
686

Repossessed assets
266

 
704

Total Nonperforming Assets
$
12,270

 
$
14,717


Nonaccrual and Past Due Loans

Nonaccrual loans are those loans which are 90 days or more delinquent and collection in full of both the principal and interest is in doubt.  Additionally, some loans that are not delinquent may be placed on nonaccrual status due to doubts about full collection of principal or interest.  When a loan is categorized as nonaccrual, the accrual of interest is discontinued and any accrued balance is reversed for financial statement purposes.  Payments of contractual interest are recognized as income only to the extent that full recovery of the principal balance of the loan is reasonably certain.  Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.  Other factors, such as the value of collateral securing the loan and the financial condition of the borrower must be considered in judgments as to potential loan loss.

Loans are considered impaired if, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement.  The measurement

25

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of impaired loans is generally based on the present value of the expected future cash flows discounted at the historical effective interest rate stipulated in the loan agreement, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral.  In measuring the fair value of the collateral, in addition to relying on third party appraisals, we use assumptions such as discount rates, and methodologies, such as comparison to the recent selling price of similar assets, consistent with those that would be utilized by unrelated third parties performing a valuation. Loans that are evaluated and determined not to meet the definition of an impaired loan are reserved for at the general reserve rate for its appropriate class.

Nonaccrual loans and accruing loans past due more than 90 days include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans.

The following table sets forth the recorded investment in nonaccrual and accruing loans past due more than 90 days by class of loans for the periods presented (in thousands):

 
June 30, 2013
 
December 31, 2012
 
Nonaccrual
 
Accruing Loans Past Due More Than 90 Days
 
Nonaccrual
 
Accruing Loans Past Due More Than 90 Days
Real Estate Loans:
 
 
 
 
 
 
 
Construction
$
1,540

 
$

 
$
2,416

 
$

1-4 Family residential
2,189

 

 
2,001

 

Other
661

 

 
1,357

 

Commercial loans
1,535

 

 
1,812

 

Loans to individuals
2,254

 

 
2,728

 
15

Total
$
8,179

 
$

 
$
10,314

 
$
15


The following tables present the aging of the recorded investment in past due loans by class of loans (in thousands):

 
June 30, 2013
 
30-59 Days
Past Due
 
60-89 Days
Past Due
 
Greater than 90 Days Past Due
 
Total Past
Due
 
Loans Not
Past Due
 
Total
Real Estate Loans:
 
 
 
 
 
 
 
 
 
 
 
Construction
$

 
$
28

 
$
1,540

 
$
1,568

 
$
121,925

 
$
123,493

1-4 Family residential
486

 
663

 
2,189

 
3,338

 
381,903

 
385,241

Other
1,872

 
476

 
661

 
3,009

 
229,623

 
232,632

Commercial loans
26

 
1,157

 
1,535

 
2,718

 
151,267

 
153,985

Municipal loans

 

 

 

 
224,134

 
224,134

Loans to individuals
5,524

 
1,140

 
2,254

 
8,918

 
165,026

 
173,944

Total
$
7,908

 
$
3,464

 
$
8,179

 
$
19,551

 
$
1,273,878

 
$
1,293,429


 
December 31, 2012
 
30-59 Days Past Due
 
60-89 Days Past Due
 
Greater than 90 Days
Past Due
 
Total Past
Due
 
Loans Not Past Due
 
Total
Real Estate Loans:
 
 
 
 
 
 
 
 
 
 
 
Construction
$
1,589

 
$

 
$
2,416

 
$
4,005

 
$
109,739

 
$
113,744

1-4 Family residential
4,450

 
977

 
2,001

 
7,428

 
361,417

 
368,845

Other
1,639

 
273

 
1,357

 
3,269

 
233,491

 
236,760

Commercial loans
769

 
175

 
1,812

 
2,756

 
157,302

 
160,058

Municipal loans
709

 

 

 
709

 
220,238

 
220,947

Loans to individuals
5,908

 
1,191

 
2,743

 
9,842

 
152,781

 
162,623

Total
$
15,064

 
$
2,616

 
$
10,329

 
$
28,009

 
$
1,234,968

 
$
1,262,977


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The following table sets forth interest income recognized on nonaccrual and restructured loans by class of loans for the periods presented. Average recorded investment is reported on a year-to-date basis (in thousands):

 
Six Months Ended
 
June 30, 2013
 
June 30, 2012
 
Average Recorded Investment
 
Interest Income Recognized
 
Accruing
 Interest at
 Original
 Contracted Rate
 
Average
Recorded
Investment
 
Interest Income Recognized
 
Accruing Interest at Original Contracted Rate
Real Estate Loans:
 
 
 
 
 
 
 
 
 
 
 
Construction
$
1,919

 
$
3

 
$
82

 
$
3,591

 
$

 
$
128

1-4 Family residential
3,121

 
20

 
82

 
2,908

 
9

 
80

Other
2,159

 
28

 
78

 
1,558

 
20

 
65

Commercial loans
1,979

 
6

 
57

 
2,010

 
12

 
55

Loans to individuals
3,030

 
150

 
300

 
2,950

 
150

 
272

Total
$
12,208

 
$
207

 
$
599

 
$
13,017

 
$
191

 
$
600


 
Three Months Ended
 
June 30, 2013
 
June 30, 2012
 
Average Recorded Investment
 
Interest Income Recognized
 
Accruing
 Interest at
 Original
 Contracted Rate
 
Average
Recorded
Investment
 
Interest Income Recognized
 
Accruing
 Interest
 at Original
 Contracted Rate
Real Estate Loans:
 
 
 
 
 
 
 
 
 
 
 
Construction
$
1,551

 
$
2

 
$
41

 
$
3,410

 
$

 
$
63

1-4 Family residential
3,238

 
5

 
42

 
3,023

 
4

 
43

Other
1,900

 
10

 
39

 
1,561

 
13

 
33

Commercial loans
1,914

 
1

 
28

 
2,134

 
7

 
28

Loans to individuals
2,689

 
54

 
162

 
2,793

 
63

 
143

Total
$
11,292

 
$
72

 
$
312

 
$
12,921

 
$
87

 
$
310



The following table sets forth impaired loans by class of loans for the periods presented (in thousands):  
 
June 30, 2013
 
Unpaid Contractual Principal Balance
 
Recorded Investment With No Allowance
 
Recorded Investment With Allowance
 
Total Recorded Investment
 
Related
 Allowance for
 Loan Losses
Real Estate Loans:
 
 
 
 
 
 
 
 
 
Construction
$
2,661

 
$

 
$
1,581

 
$
1,581

 
$
83

1-4 Family residential
3,231

 

 
3,062

 
3,062

 
235

Other
2,294

 

 
1,879

 
1,879

 
77

Commercial loans
2,058

 

 
1,834

 
1,834

 
435

Loans to individuals
3,060

 

 
2,845

 
2,845

 
1,265

Total
$
13,304

 
$

 
$
11,201

 
$
11,201

 
$
2,095



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Table of Contents


 
December 31, 2012
 
Unpaid
Contractual
Principal
Balance
 
Recorded
Investment
With No
Allowance
 
Recorded
Investment
With
Allowance
 
Total
Recorded
Investment
 
Related
 Allowance for
 Loan Losses
Real Estate Loans:
 
 
 
 
 
 
 
 
 
Construction
$
3,716

 
$

 
$
2,465

 
$
2,465

 
$
200

1-4 Family residential
2,907

 

 
2,799

 
2,799

 
222

Other
3,133

 

 
2,613

 
2,613

 
243

Commercial loans
2,215

 

 
2,043

 
2,043

 
630

Loans to individuals
3,626

 
1

 
3,359

 
3,360

 
1,428

Total
$
15,597

 
$
1

 
$
13,279

 
$
13,280

 
$
2,723


At any time a potential loss is recognized in the collection of principal, proper reserves should be allocated. Loans are charged off when deemed uncollectible. Loans are written down as soon as collection by liquidation is evident to the liquidation value of the collateral net of liquidation costs, if any, and placed in nonaccrual status.

Troubled Debt Restructurings

The restructuring of a loan is considered a TDR if both (i) the borrower is experiencing financial difficulties and (ii) the creditor has granted a concession.  Concessions may include interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules and other actions intended to minimize potential losses.

The following tables set forth the recorded investment in loans modified for the periods presented (dollars in thousands):

 
Six Months Ended June 30, 2013
 
Extend Amortization
 Period
 
Interest Rate Reductions
 
Principal Forgiveness
 
Combination (1)
 
Total Modifications
 
Number of Contracts
Real Estate Loans:
 
 
 
 
 
 
 
 
 
 
 
Construction
$
40

 
$

 
$

 
$

 
$
40

 
1

1-4 Family residential
285

 

 

 
468

 
753

 
6

Other

 

 

 
16

 
16

 
1

Commercial loans
307

 

 

 
19

 
326

 
5

Loans to individuals
14

 
185

 

 
35

 
234

 
32

Total
$
646

 
$
185

 
$

 
$
538

 
$
1,369

 
45


 
Three Months Ended June 30, 2013
 
Extend Amortization
 Period
 
Interest Rate Reductions
 
Principal Forgiveness
 
Combination (1)
 
Total Modifications
 
Number of Contracts
Real Estate Loans:
 
 
 
 
 
 
 
 
 
 
 
Construction
$

 
$

 
$

 
$

 
$

 

1-4 Family residential

 

 

 
391

 
391

 
2

Other

 

 

 
16

 
16

 
1

Commercial loans
22

 

 

 

 
22

 
1

Loans to individuals
14

 
185

 

 
28

 
227

 
30

Total
$
36

 
$
185

 
$

 
$
435

 
$
656

 
34



28

Table of Contents


 
Six Months Ended June 30, 2012
 
Extend Amortization
 Period
 
Interest Rate Reductions
 
Principal Forgiveness
 
Combination (1)
 
Total Modifications
 
Number of Contracts
Real Estate Loans:
 
 
 
 
 
 
 
 
 
 
 
Construction
$

 
$

 
$

 
$

 
$

 

1-4 Family residential
$
237

 
$
37

 
$

 
$
341

 
$
615

 
7

Other
$
89

 
$

 
$

 
$

 
$
89

 
1

Commercial loans
$
439

 
$
45

 
$

 
$
246

 
$
730

 
6

Loans to individuals
$
4

 
$

 
$
8

 
$
13

 
$
25

 
15

Total
$
769

 
$
82

 
$
8

 
$
600

 
$
1,459

 
29


 
Three Months Ended June 30, 2012
 
Extend Amortization
 Period
 
Interest Rate Reductions
 
Principal Forgiveness
 
Combination (1)
 
Total Modifications
 
Number of Contracts
Real Estate Loans:
 
 
 
 
 
 
 
 
 
 
 
Construction
$

 
$

 
$

 
$

 
$

 

1-4 Family residential
11

 

 

 
341

 
352

 
4

Other
89

 

 

 

 
89

 
1

Commercial loans
223

 

 

 
246

 
469

 
3

Loans to individuals

 

 

 
13

 
13

 
12

Total
$
323

 
$

 
$

 
$
600

 
$
923

 
20


(1)
These modifications include more than one of the following-extension of the amortization period, lowering interest rate and principal forgiveness.

The majority of loans restructured as TDRs during the six months ended June 30, 2013 and June 30, 2012 were modified to extend the maturity. Interest continues to be charged on principal balances outstanding during the term extended. Therefore, the financial effects of the recorded investment of loans restructured as TDRs during the three and six months ended June 30, 2013 and June 30, 2012 were insignificant. Generally, the loans identified as TDRs were previously reported as impaired loans prior to restructuring and therefore the modification did not impact our determination of the allowance for loan losses.
On an ongoing basis, the performance of the restructured loans is monitored for subsequent payment default. Payment default for TDRs is recognized when the borrower is 90 days or more past due. For the three and six months ended June 30, 2013, there were two loans modified as TDRs totaling $48,000 in payment default. This default did not significantly impact the determination of the allowance for loan loss. For the three and six months ended June 30, 2012, there were no defaults on loans that were modified as TDRs.
At June 30, 2013 and June 30, 2012, there were no commitments to lend additional funds to borrowers whose terms had been modified in TDRs.

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Table of Contents




7.     Long-term Obligations

Long-term obligations are summarized as follows (in thousands):
 
 
June 30,
2013
 
December 31,
2012
FHLB Advances (1)
$
441,808

 
$
369,097



 

Long-term Debt (2)
 
 
 
Southside Statutory Trust III Due 2033 (3)
20,619

 
20,619

Southside Statutory Trust IV Due 2037 (4)
23,196

 
23,196

Southside Statutory Trust V Due 2037 (5)
12,887

 
12,887

Magnolia Trust Company I Due 2035 (6)
3,609

 
3,609

Total Long-term Debt
60,311

 
60,311

Total Long-term Obligations
$
502,119

 
$
429,408


(1)
At June 30, 2013, the weighted average cost of these advances was 1.48%.  Long-term FHLB Advances have maturities ranging from July 2014 through July 2028.
(2)
This long-term debt consists of trust preferred securities that qualify under the risk-based capital guidelines as Tier 1 capital, subject to certain limitations.
(3)
This debt carries an adjustable rate of 3.214% through September 29, 2013 and adjusts quarterly at a rate equal to three-month LIBOR plus 294 basis points.
(4)
This debt carries an adjustable rate of 1.5756% through July 29, 2013 and adjusts quarterly at a rate equal to three-month LIBOR plus 130 basis points.
(5)
This debt carries an adjustable rate of 2.52325% through September 15, 2013 and adjusts quarterly at a rate equal to three-month LIBOR plus 225 basis points.
(6)
This debt carries an adjustable rate of 2.0741% through August 22, 2013 and adjusts quarterly at a rate equal to three-month LIBOR plus 180 basis points.

During 2010 and 2011, we entered into the option to fund between one and a half and two years forward from the advance commitment date $200 million par in long-term advance commitments from the FHLB at the rates on the date the option was purchased.  During the year ended December 31, 2012, $150 million par of long-term advance commitments expired unexercised. During the first quarter of 2013, the remaining $50 million par of long-term advance commitments expired unexercised.  For the three and six months ended June 30, 2012, we recorded impairment charges of $1.4 million and $1.8 million in our income statement.  At December 31, 2012, the FHLB advance option fees were fully impaired. At June 30, 2013, there were no remaining FHLB advance option fees recorded on our balance sheet.

8.     Employee Benefit Plans

The components of net periodic benefit cost are as follows (in thousands):
 
 
Six Months Ended June 30,
 
 
Defined Benefit
Pension Plan
 
Restoration
Plan
 
 
2013
 
2012
 
2013
 
2012
Service cost
 
$
1,059

 
$
868

 
$
149

 
$
80

Interest cost
 
1,577

 
1,533

 
234

 
195

Expected return on assets
 
(2,397
)
 
(2,058
)
 

 

Net loss recognition
 
1,099

 
852

 
295

 
159

Prior service credit amortization
 
(21
)
 
(21
)
 
(1
)
 
(1
)
Net periodic benefit cost
 
$
1,317

 
$
1,174

 
$
677

 
$
433



30

Table of Contents


 
 
Three Months Ended June 30,
 
 
Defined Benefit
Pension Plan
 
Restoration
Plan
 
 
2013
 
2012
 
2013
 
2012
Service cost
 
$
503

 
$
403

 
$
98

 
$
30

Interest cost
 
792

 
770

 
135

 
96

Expected return on assets
 
(1,199
)
 
(1,029
)
 

 

Net loss recognition
 
554

 
437

 
197

 
75

Prior service credit amortization
 
(10
)
 
(11
)
 
(1
)
 
(1
)
Net periodic benefit cost
 
$
640

 
$
570

 
$
429

 
$
200


Employer Contributions.  As of June 30, 2013, contributions of $5.0 million and $40,000 have been made to our defined benefit and restoration plans, respectively. We do not expect further contributions to the defined benefit plan during 2013.

9.     Share-based Incentive Plans

2009 Incentive Plan

On April 16, 2009, our shareholders approved the Southside Bancshares, Inc. 2009 Incentive Plan (the “2009 Incentive Plan”), which is a stock-based incentive compensation plan.  A total of 1,276,283 shares of our common stock were reserved and available for issuance pursuant to awards granted under the 2009 Incentive Plan.  Under the 2009 Incentive Plan, we were authorized to grant nonqualified stock options (“NQSOs”), restricted stock units (“RSUs”), or any combination thereof to certain officers.  During the first six months of 2013 and 2012, there were no grants of RSUs or NQSOs pursuant to the 2009 Incentive Plan.

As of June 30, 2013, there were 290,860 unvested awards outstanding.  For the three and six months ended June 30, 2013, there was share-based compensation expense of $166,000 and $373,000, respectively, with an associated income tax benefit for the three and six months of $58,000 and $131,000, respectively. As of June 30, 2012, there were 136,660 unvested awards outstanding.  Share-based compensation expense for the three and six months ended June 30, 2012 was $94,000 and $133,000, respectively, with an associated income tax benefit for the three and six months of $32,000 and $46,000, respectively.

As of June 30, 2013 and 2012, there was $1.7 million and $949,000 of unrecognized compensation cost related to the unvested awards outstanding. The remaining cost is expected to be recognized over a weighted-average period of 2.44 years.  

The NQSOs have contractual terms of 10 years and vest in equal annual installments over three- and four-year periods.

The fair value of each RSU is the ending stock price on the date of grant.  The RSUs vest in equal annual installments over three- and four-year periods.

Each award is evidenced by an award agreement that specifies the exercise price, if applicable, the duration of the award, the number of shares to which the award pertains, and such other provisions as the Board determines.

Shares issued in connection with stock compensation awards are issued from authorized shares and not from treasury shares.  During the six months ended June 30, 2013 and 2012, there were 9,513 and 10,031 shares, respectively, issued in connection with stock compensation awards from available authorized shares.

The following table presents activity related to our RSUs and NQSOs as of June 30, 2013.


31

Table of Contents


 
 

Restricted Stock Units
Outstanding

Stock Options
Outstanding
 
Shares
Available
for Grant

Number
of Shares

Weighted-
Average
Grant-Date
Fair Value

Number
of Shares

Weighted-
Average
Exercise
Price

Weighted-
Average
Grant-Date
Fair Value
Balance, January 1, 2013
867,057


50,178


$
18.93


349,685


$
18.82


$
5.45

Granted











Stock options exercised






(2,197
)

17.41


5.32

Stock awards vested


(7,631
)

17.41







Forfeited
18,858


(3,310
)

18.80


(15,548
)

18.87


5.44

Canceled/expired











Balance, June 30, 2013
885,915


39,237


$
19.23


331,940


$
18.82


$
5.45



Other information regarding options outstanding and exercisable as of June 30, 2013 is as follows:

 

Options Outstanding

Options Exercisable
Range of Exercise Prices

Number
of Shares

Weighted-
Average
Exercise
Price

Weighted-
Average
Remaining
Contractual
Life in Years

Number
of Shares

Weighted-
Average
Exercise
Price
$
17.41

-
19.94

331,940


$
18.82


8.58

80,317


$
17.41

Total

331,940


$
18.82


8.58

80,317


$
17.41


The total intrinsic value (i.e., the amount by which the fair value of the underlying common stock exceeds the exercise price of a stock option on exercise date) of outstanding stock options and exercisable stock options was $1.7 million and $520,000 at June 30, 2013.

Cash received from stock option exercises for the six months ended June 30, 2013 and 2012 was $38,000 and $16,000, respectively. The total intrinsic value related to stock options exercised during the six months ended June 30, 2013 and 2012, was $14,000 and $18,000, respectively. The tax benefit realized for the deductions related to the stock awards was $22,000 and $11,000, for the six months ended June 30, 2013 and 2012, respectively.   

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Table of Contents




10.     Fair Value Measurement

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.  A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability.  The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs.  An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction.  Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact and (iv) willing to transact.

Valuation techniques including the market approach, the income approach and/or the cost approach are utilized to determine fair value.  Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability.  Valuation policies and procedures are determined by our investment department and reported to our Asset/Liability Committee (“ALCO”) for review.  An entity must consider all aspects of nonperforming risk, including the entity’s own credit standing when measuring fair value of a liability.  Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from independent sources, or unobservable, meaning those that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances.  A fair value hierarchy for valuation inputs gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs.  The fair value hierarchy is as follows:

Level 1 Inputs - Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

Level 2 Inputs - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.  These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means.

Level 3 Inputs - Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity's own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

A description of the valuation methodologies used for assets and liabilities measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.
 
Securities Available for Sale – U.S. Treasury securities are reported at fair value utilizing Level 1 inputs.  Other securities classified as available for sale are reported at fair value utilizing Level 2 inputs.  For these securities, we obtain fair value measurements from independent pricing services.  The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.
 
Securities Carried at Fair Value through Income – U.S. Treasury securities are reported at fair value utilizing Level 1 inputs.  Other securities classified as available for sale are reported at fair value utilizing Level 2 inputs.  For these securities, we obtain fair value measurements from independent pricing services.  The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.
 
We review the prices quarterly supplied by the independent pricing services for reasonableness and to ensure such prices are aligned with traditional pricing matrices.  In addition, we obtain an understanding of their underlying pricing methodologies and their Statement on Standards for Attestation Engagements-Reporting on Controls of a Service Organization (“SSAE 16”).  We validate prices supplied by the independent pricing services by comparison to prices obtained from, two and in some cases, three additional third party sources.  For securities where prices are outside a reasonable range, we further review those securities to determine what a reasonable price estimate is for that security, given available data.
 

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Certain financial assets are measured at fair value in accordance with GAAP.  Adjustments to the fair value of these assets usually result from the application of fair value accounting or write-downs of individual assets.  Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally coincides with our monthly and/or quarterly valuation process.  There were no transfers between Level 1 and Level 2 during the six months ended June 30, 2013.

Loans Held for Sale - These loans are reported at the lower of cost or fair value.  Fair value is determined based on expected proceeds, which are based on sales contracts and commitments and are considered Level 2 inputs.  At June 30, 2013 and December 31, 2012, based on our estimates of fair value, no valuation allowance was recognized.

Foreclosed Assets – Foreclosed assets are initially carried at fair value less costs to sell.  The fair value measurements of foreclosed assets can include Level 2 measurement inputs such as real estate appraisals and comparable real estate sales information, in conjunction with Level 3 measurement inputs such as cash flow projections, qualitative adjustments, sales cost estimates, etc.  As a result, the categorization of foreclosed assets is Level 3 of the fair value hierarchy.  In connection with the measurement and initial recognition of certain foreclosed assets, we may recognize charge-offs through the allowance for loan losses.

Impaired Loans – Certain impaired loans may be reported at the fair value of the underlying collateral if repayment is expected solely from the collateral.  Collateral values are estimated using Level 3 inputs based on customized discounting criteria or appraisals.  At June 30, 2013 and December 31, 2012, the impact of loans with specific reserves based on the fair value of the collateral was reflected in our allowance for loan losses.

Certain nonfinancial assets and nonfinancial liabilities measured at fair value on a recurring basis include reporting units measured at fair value in the first step of a goodwill impairment test.  Certain nonfinancial assets measured at fair value on a nonrecurring basis include nonfinancial assets and nonfinancial liabilities measured at fair value in the second step of a goodwill impairment test, as well as intangible assets and other nonfinancial long-lived assets (such as real estate owned) that are measured at fair value in the event of an impairment.

The following tables summarize assets measured at fair value on a recurring and nonrecurring basis segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value (in thousands):

 
At or For the Six Months Ended June 30, 2013
 
 
 
Fair Value Measurements at the End of the Reporting Period Using
 
Carrying
Amount
 
Quoted Prices in Active Markets for Identical Assets
(Level 1)
 
Significant Other Observable Inputs
(Level 2)
 
Significant Unobservable Inputs
(Level 3)
 
Total Gains
(Losses)
Recurring fair value measurements
 
 
 
 
 
 
 
 
 
Investment Securities:
 
 
 
 
 
 
 
 
 
U.S. Government Agency Debentures
$
14,198

 
$

 
$
14,198

 
$

 
$

State and Political Subdivisions
459,827

 

 
459,827

 

 

Other Stocks and Bonds
14,296

 

 
13,152

 
1,144

 
(42
)
Mortgage-backed Securities: (1)


 
 

 


 
 

 
 

Residential
683,621

 

 
683,621

 

 

Commercial
138,139

 

 
138,139

 

 

Total recurring fair value measurements
$
1,310,081

 
$

 
$
1,308,937

 
$
1,144

 
$
(42
)
 
 
 
 
 
 
 
 
 
 
Nonrecurring fair value measurements
 

 
 

 
 

 
 

 
 

Foreclosed assets (2)
$
1,038

 
$

 
$

 
$
1,038

 
$
(365
)
Impaired loans (3)
9,106

 

 

 
9,106

 
(61
)
Total nonrecurring fair value measurements
$
10,144

 
$

 
$

 
$
10,144

 
$
(426
)

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At or For the Year Ended December 31, 2012
 
 
 
Fair Value Measurements at the End of the Reporting Period Using
 
Carrying
Amount
 
Quoted Prices in Active Markets for Identical Assets
(Level 1)
 
Significant Other Observable Inputs
(Level 2)
 
Significant Unobservable Inputs
(Level 3)
 
Total Gains
(Losses)
Recurring fair value measurements
 
 
 
 
 
 
 
 
 
Investment Securities:
 
 
 
 
 
 
 
 
 
U.S. Government Agency Debentures
$
60,863

 
$

 
$
60,863

 
$

 
$

State and Political Subdivisions
545,688

 

 
545,688

 

 

Other Stocks and Bonds
11,156

 

 
10,166

 
990

 
(181
)
Mortgage-backed Securities: (1)


 
 

 


 
 
 
 

Residential
806,360

 

 
806,360

 

 

Total recurring fair value measurements
$
1,424,067

 
$

 
$
1,423,077

 
$
990

 
$
(181
)
 
 
 
 
 
 
 
 
 
 
Nonrecurring fair value measurements
 

 
 

 
 

 
 

 
 
Foreclosed assets (2)
$
1,390

 
$

 
$

 
$
1,390

 
$
(752
)
Impaired loans (3)
10,557

 

 

 
10,557

 
(81
)
Total nonrecurring fair value measurements
$
11,947

 
$

 
$

 
$
11,947

 
$
(833
)

(1)
All mortgage-backed securities issued and/or guaranteed by U.S. government agencies or U.S. government-sponsored enterprises.
(2)
Losses represent related losses on foreclosed properties that were written down subsequent to their initial classification as foreclosed properties.
(3)
Loans represent collateral dependent impaired loans with a specific valuation allowance.  Losses on these loans represent charge-offs which are netted against the allowance for loan losses.

The following table presents additional information about financial assets and liabilities measured at fair value on a recurring basis and for which we have utilized Level 3 inputs to determine fair value (in thousands):

 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2013
 
2012
 
2013
 
2012
Other Stocks and Bonds
 
 
 
 
 
 
 
Balance at Beginning of Period
$
592

 
$
658

 
$
990

 
$
499

 
 
 
 
 


 


Total gains or losses (realized/unrealized):
 

 
 

 


 


Included in earnings

 
(40
)
 
(42
)
 
(181
)
Included in other comprehensive income (loss)
552

 
5

 
196

 
305

Purchases

 

 

 

Issuances

 

 

 

Settlements

 

 

 

Transfers in and/or out of Level 3

 

 

 

Balance at End of Period
$
1,144

 
$
623

 
$
1,144

 
$
623

 
 
 
 
 
 
 
 
The amount of total gains or losses for the periods included in earnings attributable to the change in unrealized gains or losses relating to assets still held at reporting date
$

 
$
(40
)
 
$
(42
)
 
$
(181
)


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The following table presents income statement classification of realized and unrealized gains and losses due to changes in fair value recorded in earnings for the period presented for recurring Level 3 assets, as shown in the previous tables (in thousands):
 
 
Six Months Ended June 30, 2013
 
Net Securities Gains
(Losses)
 
Other Noninterest Income
(Loss)
 
Total
AVAILABLE FOR SALE
Realized
 
Unrealized
 
Realized
 
Unrealized
 
Realized
 
Unrealized
Investment Securities:
 
 
 
 
 
 
 
 
 
 
 
Other stocks and bonds
$

 
$

 
$
(42
)
 
$

 
$
(42
)
 
$


 
Three Months Ended June 30, 2013
 
Net Securities Gains
(Losses)
 
Other Noninterest Income
(Loss)
 
Total
AVAILABLE FOR SALE
Realized
 
Unrealized
 
Realized
 
Unrealized
 
Realized
 
Unrealized
Investment Securities:
 
 
 
 
 
 
 
 
 
 
 
Other stocks and bonds
$

 
$

 
$

 
$

 
$

 
$


The following table presents quantitative information related to the significant unobservable inputs utilized in our Level 3 recurring fair value measurements as of June 30, 2013.  No liabilities were recorded as Level 3 at June 30, 2013 (in thousands):
 
AVAILABLE FOR SALE
As of June 30, 2013
Investment Securities:
Fair Value
 
Valuation Techniques
 
Unobservable Input
 
Range of Inputs
  Other stocks and bonds
$
1,144

 
Discounted Cash Flows
 
Constant prepayment rate
 
1% - 2
 
 
 
 
 
 
 
 
 
 

 
 
 
Discount Rate
 
Libor + 13% - 15
 
 
 
 
 
 
 
 
 
 
 
 
 
Loss Severity
 
25% - 100
 
The significant unobservable inputs used in the fair value measurement of our trust preferred securities (“TRUPS”) included the credit rating downgrades, the severity and duration of the mark-to-market loss, and the structural nuances of each TRUP.  Our analysis of the underlying cash flows contemplated various default, deferral and recovery scenarios to arrive at our best estimate of cash flows.  Significant increases (decreases) in any of those inputs would result in a significant lower (higher) fair value.

Level 3 assets recorded at fair value on a nonrecurring basis at June 30, 2013, included loans for which a specific allowance was established based on the fair value of collateral and other real estate for which fair value of the properties was less than the cost basis.  For both asset classes, the unobservable inputs were the additional adjustments applied by management to the appraised values to reflect such factors as non-current appraisals and revisions to estimated time to sell.  These adjustments are determined based on qualitative judgments made by management on a case-by-case basis and are not quantifiable inputs, although they are used in the determination of fair value.

We reported at fair value through income mortgage-backed securities with embedded derivatives and those purchased at a significant premium, which we defined as greater than 111.111% as opposed to bifurcating the embedded derivative and valuing it on a stand-alone basis, as these embedded derivatives are not readily identifiable and measurable, and as such cannot be bifurcated.  At June 30, 2013 and 2012, we had no securities carried at fair value through income.  During the first quarter of 2012, we sold all of our securities carried at fair value through income which resulted in a loss on sale of securities carried at fair value through income of $498,000.  

Assets and liabilities accounted for under the fair value election are initially measured at fair value with subsequent changes in fair value recognized in earnings.  Disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet is required, for which it is practicable to estimate that value.  In cases where quoted market prices are not available, fair values are based on estimates using present value or other estimation techniques.  Those techniques are significantly affected

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by the assumptions used, including the discount rate and estimates of future cash flows.  Such techniques and assumptions, as they apply to individual categories of our financial instruments, are as follows:

Cash and cash equivalents - The carrying amounts for cash and cash equivalents is a reasonable estimate of those assets' fair value.

Investment and mortgage-backed and related securities - Fair values for these securities are based on quoted market prices, where available.  If quoted market prices are not available, fair values are based on quoted market prices for similar securities or estimates from independent pricing services.

FHLB stock and other investments - The carrying amount of FHLB stock is a reasonable estimate of those assets’ fair value.

Loans receivable - For adjustable rate loans that reprice frequently and with no significant change in credit risk, the carrying amounts are a reasonable estimate of those assets' fair value.  The fair value of fixed rate loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.  Nonperforming loans are estimated using discounted cash flow analyses or the underlying value of the collateral where applicable.

Deposit liabilities - The fair value of demand deposits, savings accounts, and certain money market deposits is the amount on demand at the reporting date, that is, the carrying value.  Fair values for fixed rate CDs are estimated using a discounted cash flow calculation that applies interest rates currently being offered for deposits of similar remaining maturities.

Federal funds purchased and repurchase agreements - Federal funds purchased and repurchase agreements generally have an original term to maturity of one day and thus are considered short-term borrowings.  Consequently, their carrying value is a reasonable estimate of fair value.

FHLB advances - The fair value of these advances is estimated by discounting the future cash flows using rates at which advances would be made to borrowers with similar credit ratings and for the same remaining maturities.

Long-term debt - The carrying amount for the long-term debt is estimated by discounting future cash flows using estimated rates at which long-term debt would be made to borrowers with similar credit ratings and for the remaining maturities.  

The following tables present our financial assets, financial liabilities, and unrecognized financial instruments at both their respective carrying amounts and fair value (in thousands):

 
 
 
 
 
Estimated Fair Value
June 30, 2013
Carrying
Amount
 
Total
 
Level 1
 
Level 2
 
Level 3
Financial Assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
49,797

 
$
49,797

 
$
49,797

 
$

 
$

Investment securities:


 


 


 


 


Held to maturity, at amortized cost (Restated)
302,994

 
290,233

 

 
290,233

 

Mortgage-backed and related securities:


 


 


 


 


Held to maturity, at amortized cost
240,514

 
239,861

 

 
239,861

 

FHLB stock and other investments, at cost
29,217

 
29,217

 

 
29,217

 

Loans, net of allowance for loan losses
1,275,059

 
1,256,530

 

 

 
1,256,530

Loans held for sale
724

 
724

 

 
724

 

Financial Liabilities:


 


 


 


 


Retail deposits
$
2,499,338

 
$
2,498,520

 
$

 
$
2,498,520

 
$

Federal funds purchased and repurchase agreements
857

 
857

 

 
857

 

FHLB advances
526,690

 
515,574

 

 
515,574

 

Long-term debt
60,311

 
43,416

 

 
43,416

 



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Estimated Fair Value
December 31, 2012
Carrying
Amount
 
Total
 
Level 1
 
Level 2
 
Level 3
Financial Assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
150,630

 
$
150,630

 
$
150,630

 
$

 
$

Investment securities:


 


 
 

 
 

 
 

Held to maturity, at amortized cost
1,009

 
1,137

 

 
1,137

 

Mortgage-backed and related securities:
 

 
 

 
 

 
 

 
 

Held to maturity, at amortized cost
245,538

 
254,261

 

 
254,261

 

FHLB stock and other investments, at cost
29,953

 
29,953

 

 
29,953

 

Loans, net of allowance for loan losses
1,242,392

 
1,235,511

 

 

 
1,235,511

Loans held for sale
3,601

 
3,601

 

 
3,601

 

Financial Liabilities:
 

 


 
 

 
 

 
 

Retail deposits
$
2,351,897

 
$
2,353,613

 
$

 
$
2,353,613

 
$

Federal funds purchased and repurchase agreements
984

 
984

 

 
984

 

FHLB advances
520,082

 
520,488

 

 
520,488

 

Long-term debt
60,311

 
49,507

 

 
49,507

 


As discussed earlier, the fair value estimate of financial instruments for which quoted market prices are unavailable is dependent upon the assumptions used.  Consequently, those estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments.  Accordingly, the aggregate fair value amounts presented in the above fair value table do not necessarily represent their underlying value.

The estimated fair value of our commitments to extend credit, credit card arrangements and letters of credit, estimated using Level 3 inputs, was not material at June 30, 2013 or December 31, 2012.

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11.     Off-Balance-Sheet Arrangements, Commitments and Contingencies

Financial Instruments with Off-Balance-Sheet-Risk. In the normal course of business, we are a party to certain financial instruments, with off-balance-sheet risk, to meet the financing needs of our customers.  These off-balance-sheet instruments include commitments to extend credit and standby letters of credit.  These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount reflected in the financial statements.  The contract or notional amounts of these instruments reflect the extent of involvement and exposure to credit loss that we have in these particular classes of financial instruments.

Commitments to extend credit are agreements to lend to a customer provided that the terms established in the contract are met.  Commitments generally have fixed expiration dates and may require payment of fees.  Since some commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party.  These guarantees are primarily issued to support public and private borrowing arrangements.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers.

We had outstanding unused commitments to extend credit of $147.2 million and $132.8 million at June 30, 2013 and December 31, 2012, respectively.  Each commitment has a maturity date and the commitment expires on that date with the exception of credit card and ready reserve commitments, which have no stated maturity date.  Unused commitments for credit card and ready reserve at June 30, 2013 and December 31, 2012 were $13.4 million and $13.0 million, respectively, and are reflected in the due after one year category.  We had outstanding standby letters of credit of $5.7 million and $5.6 million at June 30, 2013 and December 31, 2012, respectively.

The scheduled maturities of unused commitments were as follows (in thousands):
 
At
June 30,
2013
 
At
December 31,
2012
Unused commitments:
 

 
 

Due in one year or less
$
111,541

 
$
84,756

Due after one year
35,639

 
48,061

Total
$
147,180

 
$
132,817


We apply the same credit policies in making commitments and standby letters of credit as we do for on-balance-sheet instruments.  We evaluate each customer's credit worthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary, upon extension of credit is based on management's credit evaluation of the borrower.  Collateral held varies but may include cash or cash equivalents, negotiable instruments, real estate, accounts receivable, inventory, oil, gas and mineral interests, property, plant and equipment.

Lease Commitments. We lease certain branch facilities and office equipment under operating leases.  It is expected that certain leases will be renewed, or equipment replaced with new leased equipment, as these leases expire.

Securities. In the normal course of business we buy and sell securities.  There were $27.8 million and $10.0 million of unsettled trades to purchase at June 30, 2013 and December 31, 2012, respectively.  There were no unsettled trades to sell securities as of June 30, 2013 or December 31, 2012.  

Deposits. There were $11.1 million unsettled issuances of brokered CDs at June 30, 2013. There were no unsettled issuance of brokered CDs at December 31, 2012.

Litigation. We are involved with various litigation in the normal course of business.  Management, after consulting with our legal counsel, believes that any liability resulting from litigation will not have a material effect on the financial position and results of operations and our liquidity.

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ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following is a discussion of the consolidated financial condition, changes in financial condition, and results of our operations, and should be read and reviewed in conjunction with the financial statements, and the notes thereto, in this Quarterly Report on Form 10-Q/A and in our Annual Report on Form 10-K for the year ended December 31, 2012 .

We reported an increase in net income for the three and six months ended June 30, 2013 compared to the same period in 2012 .  Net income on a restated basis for the three and six months ended June 30, 2013 was $11.1 million and $20.1 million , respectively, compared to $7.7 million and $17.9 million , respectively, for the same period in 2012 .

As more fully described in Note 2 of the Notes to Financial Statements, certain financial statement components for the three and six months ended June 30, 2013 have been restated to reflect the recognition of interest income on our municipal securities purchased at a premium based on amortizing the premium to the maturity of the security. Throughout this discussion we will footnote tables that have been restated for the three and six months ended June 30, 2013 to reflect the impact of this restatement and we have updated our discussion to discuss changes between periods when comparing the restated amounts.

Forward Looking Statements

Certain statements of other than historical fact that are contained in this document and in written material, press releases and oral statements issued by or on behalf of Southside Bancshares, Inc., a bank holding company, may be considered to be “forward-looking statements” within the meaning of and subject to the protections of the Private Securities Litigation Reform Act of 1995.  These forward-looking statements are not guarantees of future performance, nor should they be relied upon as representing management’s views as of any subsequent date.  These statements may include words such as “expect,” “estimate,” “project,” “anticipate,” “appear,” “believe,” “could,” “should,” “may,” “intend,” “probability,” “risk,” “target,” “objective,” “plans,” “potential,” and similar expressions.  Forward-looking statements are statements with respect to our beliefs, plans, expectations, objectives, goals, anticipations, assumptions, estimates, intentions and future performance, and are subject to significant known and unknown risks and uncertainties, which could cause our actual results to differ materially from the results discussed in the forward-looking statements.  For example, discussions of the effect of our expansion, trends in asset quality, and earnings from growth, and certain market risk disclosures are based upon information presently available to management and are dependent on choices about key model characteristics and assumptions and are subject to various limitations.  By their nature, certain of the market risk disclosures are only estimates and could be materially different from what actually occurs in the future.  As a result, actual income gains and losses could materially differ from those that have been estimated.  Other factors that could cause actual results to differ materially from forward-looking statements include, but are not limited to, the following:

general economic conditions, either globally, nationally, in the State of Texas, or in the specific markets in which we operate, including, without limitation, the deterioration of the commercial real estate, residential real estate, construction and development, credit and liquidity markets, which could cause an adverse change in our net interest margin, or a decline in the value of our assets, which could result in realized losses;
legislation, regulatory changes or changes in monetary or fiscal policy that adversely affect the businesses in which we are engaged, including the impact of the Dodd-Frank Act, the Federal Reserve’s actions with respect to interest rates and other regulatory responses to current economic conditions;
adverse changes in the status or financial condition of the Government-Sponsored Enterprises (the “GSEs”) impacting the GSEs’ guarantees or ability to pay or issue debt;
adverse changes in the credit portfolio of other U.S. financial institutions relative to the performance of certain of our investment securities;
economic or other disruptions caused by acts of terrorism in the United States, Europe or other areas;
changes in the interest rate yield curve such as flat, inverted or steep yield curves, or changes in the interest rate environment that impact interest margins and may impact prepayments on the mortgage-backed securities portfolio;
increases in our nonperforming assets;
our ability to maintain adequate liquidity to fund operations and growth;
the failure of our assumptions underlying allowance for loan losses and other estimates;
unexpected outcomes of, and the costs associated with, existing or new litigation involving us;
changes impacting our balance sheet and leverage strategy;
risks related to actual U.S. agency mortgage-backed securities prepayments exceeding projected prepayment levels;
risks related to U.S. agency mortgage-backed securities prepayments increasing due to U.S. Government programs designed to assist homeowners to refinance their mortgage that might not otherwise have qualified;
our ability to monitor interest rate risk;
significant increases in competition in the banking and financial services industry;

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changes in consumer spending, borrowing and saving habits;
technological changes;
our ability to increase market share and control expenses;
the effect of changes in federal or state tax laws;
the effect of compliance with legislation or regulatory changes;
the effect of changes in accounting policies and practices;
risks of mergers and acquisitions including the related time and cost of implementing transactions and the potential failure to achieve expected gains, revenue growth or expense savings;
credit risks of borrowers, including any increase in those risks due to changing economic conditions; and
risks related to loans secured by real estate, including the risk that the value and marketability of collateral could decline.

All written or oral forward-looking statements made by us or attributable to us are expressly qualified by this cautionary notice.  We disclaim any obligation to update any factors or to announce publicly the result of revisions to any of the forward-looking statements included herein to reflect future events or developments.

Impact of Dodd-Frank Act

On July 21, 2010, the Dodd-Frank Act was signed into law. The Dodd-Frank Act represents a significant overhaul of many aspects of the regulation of the financial services industry, although some of its provisions apply to companies that are significantly larger than us. The Dodd-Frank Act directs applicable regulatory authorities to promulgate regulations implementing many of its provisions. Regulatory agencies are still in the process of issuing regulations, rules and reporting requirements as mandated by the Dodd-Frank Act.  The effect of the Dodd-Frank Act on us and the financial services industry as a whole will continue to be clarified as further regulations are issued.  Major elements of the Dodd-Frank Act include:

A permanent increase in deposit insurance coverage to $250,000 per account, and an increase in the minimum Deposit Insurance Fund reserve requirement from 1.15% to 1.35%, with assessments to be based on assets as opposed to deposits;
New disclosure and other requirements relating to executive compensation and corporate governance;
New prohibitions and restrictions on the ability of a banking entity and nonbank financial company to engage in proprietary trading and have certain interests in, or relationships with, a hedge fund or private equity fund;
Amendments to the Truth in Lending Act aimed at improving consumer protections with respect to mortgage originations, including originator compensation, minimum repayment standards, and prepayment considerations;
The establishment of the Financial Stability Oversight Council, which will be responsible for identifying and monitoring systemic risks posed by financial firms, activities, and practices;
The development of regulations to limit debit card interchange fees;
The future elimination of newly issued trust preferred securities as a permitted element of Tier 1 capital;
The creation of a special regime to allow for the orderly liquidation of systemically important financial companies, including the establishment of an orderly liquidation fund;
The development of regulations to address derivatives markets, including clearing and exchange trading requirements and a framework for regulating derivatives-market participants;
Enhanced supervision of credit rating agencies through the Office of Credit Ratings within the SEC;
Increased regulation of asset-backed securities, including a requirement that issuers of asset-backed securities retain at least 5% of the risk of the asset-backed securities; and
The establishment of a Bureau of Consumer Financial Protection with centralized authority, including examination and enforcement authority, for consumer protection in the banking industry.

We are continuing to evaluate the potential impact of the Dodd-Frank Act on our business, financial condition and results of operations and expect that some provisions may have adverse effects on us, such as the cost of complying with the numerous new regulations and reporting requirements mandated by the Dodd-Frank Act.

Critical Accounting Estimates

Our accounting and reporting estimates conform with U.S. generally accepted accounting principles (“GAAP”) and general practices within the financial services industry.  The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes.  Actual results could differ from those estimates.  We consider our critical accounting policies to include the following:

Allowance for Losses on Loans.  The allowance for losses on loans represents our best estimate of probable losses inherent in the existing loan portfolio.  The allowance for losses on loans is increased by the provision for losses on loans charged to expense and reduced by loans charged-off, net of recoveries.  The provision for losses on loans is determined based on our assessment of

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several factors:  reviews and evaluations of specific loans, changes in the nature and volume of the loan portfolio, current economic conditions and the related impact on specific borrowers and industry groups, historical loan loss experience, the level of classified and nonperforming loans and the results of regulatory examinations.

The loan loss allowance is based on the most current review of the loan portfolio and is validated by multiple processes.  The servicing officer has the primary responsibility for updating significant changes in a customer's financial position.  Each officer prepares status updates on any credit deemed to be experiencing repayment difficulties which, in the officer's opinion, would place the collection of principal or interest in doubt.  Our internal loan review department is responsible for an ongoing review of our loan portfolio with specific goals set for the loans to be reviewed on an annual basis.

At each review, a subjective analysis methodology is used to grade the respective loan.  Categories of grading vary in severity from loans that do not appear to have a significant probability of loss at the time of review to loans that indicate a probability that the entire balance of the loan will be uncollectible.  If full collection of the loan balance appears unlikely at the time of review, estimates of future expected cash flows or appraisals of the collateral securing the debt are used to allocate the necessary allowances.  The internal loan review department maintains a list of all loans or loan relationships that are graded as having more than the normal degree of risk associated with them.  In addition, a list of specifically reserved loans or loan relationships of $50,000 or more is updated on a quarterly basis in order to properly allocate the necessary allowance and keep management informed on the status of attempts to correct the deficiencies noted with respect to the loan.

Loans are considered impaired if, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement.  The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate stipulated in the loan agreement, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral.  In measuring the fair value of the collateral, in addition to relying on third party appraisals, we use assumptions such as discount rates, and methodologies, such as comparison to the recent selling price of similar assets, consistent with those that would be utilized by unrelated third parties performing a valuation.

Changes in the financial condition of individual borrowers, economic conditions, historical loss experience and the conditions of the various markets in which collateral may be sold all may affect the required level of the allowance for losses on loans and the associated provision for loan losses.

As of June 30, 2013, our review of the loan portfolio indicated that a loan loss allowance of $18.4 million was appropriate to cover probable losses in the portfolio.

Refer to “Part II - Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Loan Loss Experience and Allowance for Loan Losses” and “Note 5– Loans and Allowance for Probable Loan Losses” of the Notes to Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2012 for a detailed description of our estimation process and methodology related to the allowance for loan losses.

Estimation of Fair Value.  The estimation of fair value is significant to a number of our assets and liabilities.  In addition, GAAP requires disclosure of the fair value of financial instruments as a part of the notes to the consolidated financial statements.  Fair values for securities are volatile and may be influenced by a number of factors, including market interest rates, prepayment speeds, discount rates and the shape of yield curves.  Fair values for most investment and mortgage-backed securities are based on quoted market prices, where available.  If quoted market prices are not available, fair values are based on the quoted prices of similar instruments or estimates from independent pricing services.  Where there are price variances outside certain ranges from different pricing services for specific securities, those pricing variances are reviewed with other market data to determine which of the price estimates is appropriate for that period.  For securities carried at fair value through income, the change in fair value from the prior period is recorded on our income statement as fair value gain (loss) – securities.

At September 30, 2008 and continuing at June 30, 2013, the valuation inputs for our available for sale ("AFS") trust preferred securities ("TRUPs") became unobservable as a result of the significant market dislocation and illiquidity in the marketplace.  We continue to rely on nonbinding prices compiled by third party vendors which we have verified to be an appropriate measure of fair value. However, the significant illiquidity in this market results in a fair value not clearly based on observable market data but rather a range of fair value data points from the market place. Accordingly, we determined that the TRUPs security valuation is based on Level 3 inputs.

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Impairment of Investment Securities and Mortgage-backed Securities.  Investment and mortgage-backed securities classified as AFS are carried at fair value and the impact of changes in fair value are recorded on our consolidated balance sheet as an unrealized gain or loss in “Accumulated other comprehensive income (loss),” a separate component of shareholders’ equity.  Securities classified as AFS or held to maturity ("HTM") are subject to our review to identify when a decline in value is other-than-temporary.  When it is determined that a decline in value is other-than-temporary, the carrying value of the security is reduced to its estimated fair value, with a corresponding charge to earnings for the credit portion and to other comprehensive income for the noncredit portion.  Factors considered in determining whether a decline in value is other-than-temporary include: (1) whether the decline is substantial; the duration of the decline; the reasons for the decline in value; (2) whether the decline is related to a credit event, a change in interest rate or a change in the market discount rate; (3) the financial condition and near-term prospects of the issuer; and (4) whether we have a current intent to sell the security and whether it is not more likely than not that we will be required to sell the security before the anticipated recovery of its amortized cost basis. For certain assets we consider expected cash flows of the investment in determining if impairment exists.
 
At June 30, 2013, we have in AFS Other Stocks and Bonds $2.7 million amortized cost basis in pooled TRUPs.  Those securities are structured products with cash flows dependent upon securities issued by U.S. financial institutions, including banks and insurance companies.  Our estimate of fair value at June 30, 2013, for the TRUPs is approximately $1.1 million and reflects the market illiquidity.  With the exception of the TRUPs, to the best of management’s knowledge and based on our consideration of the qualitative factors associated with each security, there were no securities in our investment and mortgage-backed securities portfolio at June 30, 2013, with an other-than-temporary impairment.  Given the facts and circumstances associated with the TRUPs, we performed detailed cash flow modeling for each TRUP using an industry accepted model.  Prior to loading the required assumptions into the model, we reviewed the financial condition of the underlying issuing banks within the TRUP collateral pool that had not deferred or defaulted as of June 30, 2013.
 
Management’s best estimate of a default assumption, based on a third party method, was assigned to each issuing bank based on the category in which it fell.  Our analysis of the underlying cash flows contemplated various default, deferral and recovery scenarios to arrive at our best estimate of cash flows.  Based on that detailed analysis, we have estimated the credit component at $3.3 million at June 30, 2013 and at December 31, 2012.  The noncredit charge to other comprehensive income was estimated at $1.6 million and $1.8 million at June 30, 2013 and December 31, 2012, respectively.  The carrying amount of the TRUPs was written down with $42,000 recognized in earnings for the six months ended June 30, 2013, and $181,000 during the year ended December 31, 2012. The cash flow model assumptions represent management’s best estimate and consider a variety of qualitative factors, which include, among others, the credit rating downgrades, severity and duration of the mark-to-market loss, and structural nuances of each TRUP.  Management believes the detailed review of the collateral and cash flow modeling support the conclusion that the TRUPs had an other-than-temporary impairment at June 30, 2013.  We will continue to update our assumptions and the resulting analysis each reporting period to reflect changing market conditions.  Additionally, we do not currently intend to sell the TRUPs and it is not more likely than not that we will be required to sell the TRUPs before the anticipated recovery of their amortized cost basis.

Defined Benefit Pension Plan. The plan obligations and related assets of our defined benefit pension plan (the “Plan”) are presented in “Note 11 – Employee Benefits” of the Notes to Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2012.  Entry into the Plan by new employees was frozen effective December 31, 2005.  Plan assets, which consist primarily of marketable equity and debt instruments, are valued using observable market quotations.  Plan obligations and the annual pension expense are determined by independent actuaries and through the use of a number of assumptions that are reviewed by management.  Key assumptions in measuring the plan obligations include the discount rate, the rate of salary increases and the estimated future return on plan assets.  In determining the discount rate, we utilized a cash flow matching analysis to determine a range of appropriate discount rates for our defined benefit pension and restoration plans.  In developing the cash flow matching analysis, we constructed a portfolio of high quality noncallable bonds (rated AA- or better) to match as close as possible the timing of future benefit payments of the plans at December 31, 2012.  Based on this cash flow matching analysis, we were able to determine an appropriate discount rate.

Salary increase assumptions are based upon historical experience and our anticipated future actions.  The expected long-term rate of return assumption reflects the average return expected based on the investment strategies and asset allocation on the assets invested to provide for the Plan’s liabilities.  We considered broad equity and bond indices, long-term return projections, and actual long-term historical Plan performance when evaluating the expected long-term rate of return assumption.  At June 30, 2013, the weighted-average actuarial assumptions of the Plan were: a discount rate of 4.08%; a long-term rate of return on Plan assets of 7.25%; and assumed salary increases of 4.50%.  Material changes in pension benefit costs may occur in the future due to changes in these assumptions.  Future annual amounts could be impacted by changes in the number of Plan participants, changes in the level of benefits provided, changes in the discount rates, changes in the expected long-term rate of return, changes in the level of contributions to the Plan and other factors.

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Long-term Advance Commitments. During 2010 and 2011, we entered into the option to fund between one and a half years and two years forward from the advance commitment date, $200 million par in long-term advance commitments from the FHLB at the FHLB rates on the date the option was purchased. During the first quarter of 2013, the remaining $50 million par of long-term commitments expired unexercised.

Off-Balance-Sheet Arrangements, Commitments and Contingencies

Details of our off-balance-sheet arrangements, commitments and contingencies as of June 30, 2013, and December 31, 2012, are included in “Note 11 – Off-Balance-Sheet Arrangements, Commitments and Contingencies” in the accompanying Notes to Financial Statements included in this report.

Balance Sheet Strategy

We utilize wholesale funding and securities to enhance our profitability and balance sheet composition by determining acceptable levels of credit, interest rate and liquidity risk consistent with prudent capital management.  This balance sheet strategy consists of borrowing a combination of long and short-term funds from the FHLB, and when determined appropriate, issuing brokered CDs.  These funds are invested primarily in U.S. agency mortgage-backed securities, and to a lesser extent, long-term municipal securities.  Although U.S. agency mortgage-backed securities often carry lower yields than traditional mortgage loans and other types of loans we make, these securities generally (i) increase the overall quality of our assets because of either the implicit or explicit guarantees of the U.S. Government, (ii) are more liquid than individual loans and (iii) may be used to collateralize our borrowings or other obligations.  While the strategy of investing a substantial portion of our assets in U.S. agency mortgage-backed securities and municipal securities has historically resulted in lower interest rate spreads and margins, we believe that the lower operating expenses and reduced credit risk combined with the managed interest rate risk of this strategy have enhanced our overall profitability over the last several years.  At this time, we utilize this balance sheet strategy with the goal of enhancing overall profitability by maximizing the use of our capital.

Risks associated with the asset structure we maintain include a lower net interest rate spread and margin when compared to our peers, changes in the slope of the yield curve, which can reduce our net interest rate spread and margin, increased interest rate risk, the length of interest rate cycles, changes in volatility spreads associated with the mortgage-backed securities and municipal securities, the unpredictable nature of mortgage-backed securities prepayments and credit risks associated with the municipal securities.  See “Part I - Item 1A.  Risk Factors – Risks Related to Our Business” in our annual report on Form 10-K for the year ended December 31, 2012, for a discussion of risks related to interest rates.  Our asset structure, net interest spread and net interest margin require us to closely monitor our interest rate risk.  An additional risk is the change in fair value of the AFS securities portfolio as a result of changes in interest rates.  Significant increases in interest rates, especially long-term interest rates, could adversely impact the fair value of the AFS securities portfolio, which could also significantly impact our equity capital.  Due to the unpredictable nature of mortgage-backed securities prepayments, the length of interest rate cycles, and the slope of the interest rate yield curve, net interest income could fluctuate more than simulated under the scenarios modeled by our ALCO and described under “Item 3.  Quantitative and Qualitative Disclosures about Market Risk” in this report.

Determining the appropriate size of the balance sheet is one of the critical decisions any bank makes.  Our balance sheet is not merely the result of a series of micro-decisions, but rather the size is controlled based on the economics of assets compared to the economics of funding.

The management of our securities portfolio as a percentage of earning assets is guided by changes in our overall loan and deposit levels, combined with changes in our wholesale funding levels.  If adequate quality loan growth is not available to achieve our goal of enhancing profitability by maximizing the use of capital, as described above, then we could purchase additional securities, if appropriate, which could cause securities as a percentage of earning assets to increase.  Should we determine that increasing the securities portfolio or replacing the current securities maturities and principal payments is not an efficient use of capital, we could decrease the level of securities through proceeds from maturities, principal payments on mortgage-backed securities or sales.  Our balance sheet strategy is designed such that our securities portfolio should help mitigate financial performance associated with slower loan growth and higher credit costs.

The quarter ended June 30, 2013 , was marked by proactive management of the securities portfolio which included restructuring a portion of the portfolio. During the quarter ended June 30, 2013 , we sold long duration, lower coupon municipal securities, U.S. Agency Commercial MBS, U.S. Agency MBS and to a lesser extent, U.S. Agency debentures and taxable municipals. The sale of these securities resulted in a gain on the sale of available for sale securities of $5.0 million during the three months ended June 30, 2013 . Purchases included 5.00% coupon general market municipal securities, U.S. Agency Commercial MBS with maturities less than ten years and short duration U.S. Agency MBS at lower premiums that created a favorable risk reward scenario. At

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June 30, 2013 , total unamortized premium for our MBS decreased to approximately $33 million from approximately $91.2 million at June 30, 2012 .  Our investment securities and U.S. agency mortgage-backed securities increase d from $1.67 billion at December 31, 2012 to $1.85 billion at June 30, 2013 .  The average coupon of the mortgage-backed securities portfolio decrease d to 4.43% at June 30, 2013 from 5.11% at December 31, 2012 . The average coupon of the municipal securities portfolio increased to 4.79% at June 30, 2013 when compared to 4.14% at December 31, 2012 . At June 30, 2013 , securities as a percentage of assets increased to 54.7% as compared to 51.6% at December 31, 2012 , primarily as a result of the strategic increase in the securities portfolio during the first quarter.  Our balance sheet management strategy is dynamic and will be continually reevaluated as market conditions warrant.  As interest rates, yield curves, mortgage-backed securities prepayments, funding costs, security spreads and loan and deposit portfolios change, our determination of the proper types and maturities of securities to own, proper amount of securities to own and funding needs and funding sources will continue to be reevaluated.  Should the economics of purchasing securities remain the same or decrease, we will likely allow this part of the balance sheet to shrink through run-off or security sales.  However, should the economics become more attractive, we might strategically increase the securities portfolio and the balance sheet. Given the current low interest rate environment, our portfolio decisions reflect our significant focus on interest rate risk. We will continue to manage the balance sheet with the knowledge that at some point we are likely to transition to a higher interest rate environment.

With respect to liabilities, we continue to utilize a combination of FHLB advances and deposits to achieve our strategy of minimizing cost while achieving overall interest rate risk objectives as well as the liability management objectives of the ALCO. Our FHLB borrowings at June 30, 2013, increased 1.3%, or $6.6 million, to $526.7 million from $520.1 million at December 31, 2012, primarily as a result of an increase in the securities portfolio.  During April 2013, we prepaid $66.2 million of FHLB advances with an average rate of 4.03%. In June 2013 we prepaid an additional $24 million of FHLB advances with an average rate of 3.02%. This represented all of our higher priced advances maturing through February 2014. We paid a prepayment fee of $1.0 million which was more than offset by gains on available for sale securities. We will continue to purchase long-term FHLB advances as a hedge against future potential high interest rates. Our long-term brokered CDs increased from $19.5 million at March 31, 2013, to $36.0 million at June 30, 2013.  All of the long-term brokered CDs, except for one $5.0 million CD, have short-term calls that we control.  As interest rates have increased, we have started issuing more callable long-term CDs because we believe the value of the call has increased. We utilized long-term callable brokered CDs because the brokered CDs better matched overall ALCO objectives at the time of issuance by protecting us with fixed rates should interest rates increase, while providing us options to call the funding should interest rates decrease.  We are actively evaluating the callable brokered CDs and may exercise the call option if there is an economic benefit.  Our wholesale funding policy currently allows maximum brokered CDs of $180 million; however, this amount could be increased to match changes in ALCO objectives.  The potential higher interest expense and lack of customer loyalty are risks associated with the use of brokered CDs.  Overall growth in deposits, not including brokered CDs, resulted in a decrease in our total wholesale funding as a percentage of deposits, not including brokered CDs, to 22.8% at June 30, 2013, from 28.7% at June 30, 2012 and 23.1% at December 31, 2012.

Net Interest Income (2013 Restated)

Net interest income is one of the principal sources of a financial institution's earnings stream and represents the difference or spread between interest and fee income generated from interest earning assets and the interest expense paid on deposits and borrowed funds.  Fluctuations in interest rates or interest rate yield curves, as well as repricing characteristics and volume, and changes in the mix of interest earning assets and interest bearing liabilities, materially impact net interest income.

Net interest income for the six months ended June 30, 2013 was $46.3 million , a decrease of $210,000 , or 0.5% , compared to the same period in 2012 .

During the six months ended June 30, 2013 , total interest income decrease d $5.4 million , or 8.8% , to $55.8 million compared to $61.2 million , for the same period in 2012 .  The decrease in total interest income was the result of a decrease in the average yield on average interest earning assets from 4.32% for the six months ended June 30, 2012 to 4.12% for the six months ended June 30, 2013 , which more than offset the increase in average interest earning assets of $6.1 million , or 0.2% , from $3.06 billion to $3.07 billion .  Total interest expense decrease d $5.2 million , or 35.4% , to $9.4 million , during the six months ended June 30, 2013 , as compared to $14.6 million during the same period in 2012 .  The decrease was attributable to a decrease in the average yield on interest bearing liabilities for the six months ended June 30, 2013 , to 0.79% from 1.21% for the same period in 2012 , and the decrease in average interest bearing liabilities of $31.2 million , or 1.3% , from $2.44 billion for the six months ended June 30, 2012 , to $2.41 billion for the same period in 2013 .

Net interest income increase d during the three months ended June 30, 2013 when compared to the same period in 2012 as a result of a decrease in interest expense which was partially offset by a decrease in interest income primarily driven by a decrease in mortgage-backed and related securities investment income.  Our average interest earning assets during this period increase d $4.7 million , or 0.2% .  The decrease in the average yield on interest bearing liabilities of 41 basis points is a result of an overall decrease

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in interest rates compared to the same period in 2012 and higher priced FHLB advances that matured or were prepaid being replaced with lower cost funding.  For the three months ended June 30, 2013 , our net interest spread and net interest margin increase d to 3.51% and 3.66% , respectively, from 2.98% and 3.21% when compared to the same period in 2012 .

During the six months ended June 30, 2013 , average loans increase d $140.6 million , or 12.4% , compared to the same period in 2012 .  1-4 Family Residential loans represent a large part of this increase.  The average yield on loans decrease d from 6.39% for the six months ended June 30, 2012 to 5.99% for the six months ended June 30, 2013 .  The increase in interest income on loans of $1.8 million , or 5.1% , to $36.1 million for the six months ended June 30, 2013 , when compared to $34.3 million for the same period in 2012 was the result of an increase in the average balance which more than offset the decrease in the average yield.  The decrease in the yield on loans was due to overall lower interest rates.  For the three months ended June 30, 2013 , average loans increase d $123.4 million , or 10.6% , to $1.29 billion , when compared to $1.17 billion for the same period in 2012 .  The average yield on loans decrease d from 6.37% for the three months ended June 30, 2012 to 6.01% for the three months ended June 30, 2013 .  Due to the competitive loan pricing environment, we anticipate that we may be required to continue to offer lower interest rate loans that compete with those offered by other financial institutions in order to retain quality loan relationships.  Offering lower interest rate loans could impact the overall loans yield and, therefore, profitability.

Average investment and mortgage-backed securities decrease d $169.7 million , or 9.0% , from $1.88 billion to $1.71 billion , for the six months ended June 30, 2013 , when compared to the same period in 2012 .  At June 30, 2013 , most of our mortgage-backed securities were fixed rate securities and less than two percent were variable rate mortgage-backed securities.  The overall yield on average investment and mortgage-backed securities decrease d to 2.90% during the six months ended June 30, 2013 , from 3.17% during the same period in 2012 .  The decrease in the average yield primarily reflects an increase in prepayments on the mortgage-backed securities combined with the purchase of new securities in an overall lower interest rate environment due to the decrease in the average interest rates during 2013 .  Interest income on investment and mortgage-backed securities decrease d $7.2 million during the six months ended June 30, 2013 , or 26.8% , compared to the same period in 2012 due to a decrease in the average yield and average balance.  For the three months ended June 30, 2013 , average investment and mortgage-backed securities decrease d $150.4 million , or 7.8% , to $1.77 billion , when compared to $1.92 billion for the same period in 2012 .  The overall yield on average investment and mortgage-backed securities increase d to 3.08% during the three months ended June 30, 2013 , from 2.80% during the same period in 2012 primarily as a result of an increase in municipal securities.  Interest income from investment and mortgage-backed securities decrease d $1.1 million , or 9.3% , to $10.8 million for the three months ended June 30, 2013 , compared to $11.9 million for the same period in 2012 .  The increase in the average yield primarily reflects the change in the mix in total securities to more heavily weight higher yielding municipal securities during 2013 , which was partially offset by an increase in prepayments on the mortgage-backed securities during 2013 , when compared to 2012 and the purchase of lower yielding securities, when compared to both those securities paying off or maturing and securities sold including the securities carried at fair value through income.  The decrease in interest income for the three months is due to a decrease in average balance which was partially offset by an increase in the average yield.

Average FHLB stock and other investments decreased $6.6 million, or 19.0%, to $28.0 million, for the six months ended June 30, 2013, when compared to $34.6 million for the same period in 2012 due to a decrease in average FHLB advances during 2013 and the corresponding requirement to hold stock associated with those advances.  Interest income from our FHLB stock and other investments decreased $34,000, or 25.6%, during the six months ended June 30, 2013, when compared to the same period in 2012 due to a decrease in the average balance and average yield from 0.77% for the six months ended June 30, 2012, compared to 0.71% for the same period in 2013.  For the three months ended June 30, 2013, average FHLB stock and other investments decreased $6.1 million, or 17.4%, to $29.1 million, when compared to $35.2 million for the same period in 2012.  Interest income from FHLB stock and other investments decreased $20,000, or 37.0%, to $34,000, for the three months ended June 30, 2013, when compared to $54,000 for the same period in 2012 as a result of the decrease in the average balance and average yield from 0.62% in 2012 to 0.47% in 2013. The FHLB stock is a variable instrument with the rate typically tied to the federal funds rate.  We are required as a member of the FHLB to own a specific amount of stock that changes as the level of our FHLB advances and asset size change. 

Average interest earning deposits increased $41.6 million, or 282.2%, to $56.4 million, for the six months ended June 30, 2013, when compared to $14.8 million for the same period in 2012.  Interest income from interest earning deposits increased $63,000, or 420.0%, for the six months ended June 30, 2013, when compared to the same period in 2012, as a result of the increase in the average balance and the average yield from 0.20% in 2012 to 0.28% in 2013.  Average interest earning deposits increased $38.1 million, or 463.6%, to $46.4 million, for the three months ended June 30, 2013, when compared to $8.2 million for the same period in 2012.  Interest income from interest earning deposits increased $26,000 for the three months ended June 30, 2013, when compared to the same period in 2012, as a result of an increase in the average balance, which more than offset the decrease in the average yield from 0.44% in 2012 to 0.30% in 2013.


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During the six months ended June 30, 2013 , our average loans increased while our average securities decreased compared to the same period in 2012 .  The mix of our average interest earning assets reflected a decrease in average total securities as a percentage of total average interest earning assets as average securities decreased to 56.5% during the six months ended June 30, 2013 , compared to 62.3% during the same period in 2012 . Average loans increase d to 41.7% of average total interest earning assets and other interest earning asset categories averaged 1.8% for the six months ended June 30, 2013 .  During 2012 , the comparable mix was 37.2% in loans and 0.5% in the other interest earning asset categories.

Total interest expense decreased $5.2 million, or 35.4%, to $9.4 million during the six months ended June 30, 2013, as compared to $14.6 million during the same period in 2012.  The decrease was primarily attributable to decreased funding costs as the average yield on interest bearing liabilities decreased from 1.21% for the six months ended June 30, 2012, to 0.79% for the six months ended June 30, 2013, and a decrease in average interest bearing liabilities during this same period.  The decrease in average interest bearing liabilities of $31.2 million, or 1.3%, included a decrease in short-term interest bearing liabilities of $159.9 million, or 51.2%, partially offset by an increase in interest bearing deposits of $19.8 million, or 1.1%, and an increase in long-term FHLB advances of $108.8 million, or 37.6%.   For the three months ended June 30, 2013, total interest expense decreased $2.6 million, or 37.0%, to $4.3 million, compared to $6.9 million for the same period in 2012, as a result of a decrease in the average yield and average balance on interest bearing liabilities.  Average interest bearing liabilities decreased $39.1 million, or 1.6%, and the average yield decreased from 1.12% for the three months ended June 30, 2012, to 0.71% for the three months ended June 30, 2013.

Average interest bearing deposits increased $19.8 million, or 1.1%, from $1.78 billion to $1.80 billion, while the average rate paid decreased from 0.70% for the six months ended June 30, 2012, to 0.46% for the six months ended June 30, 2013.  For the three months ended June 30, 2013, average interest bearing deposits increased $61.0 million, or 3.5%, to $1.80 billion, when compared to $1.74 billion for the same period in 2012, while the average rate paid decreased from 0.64% for the three months ended June 30, 2012, to 0.45% for the three months ended June 30, 2013.  Average time deposits decreased $203.6 million, or 24.8%, from $821.8 million to $618.2 million, and the average rate paid decreased to 0.74% for the six months ended June 30, 2013, as compared to 1.07% for the same period in 2012.  Average interest bearing demand deposits increased $211.6 million, or 24.6%, while the average rate paid decreased to 0.32% for the six months ended June 30, 2013, as compared to 0.40% for the same period in 2012.  Average savings deposits increased $11.8 million, or 12.5%, while the average rate paid decreased to 0.13% for the six months ended June 30, 2013, as compared to 0.16% for the same period in 2012.  Interest expense for interest bearing deposits for the six months ended June 30, 2013, decreased $2.1 million, or 33.9%, when compared to the same period in 2012 due to the decrease in the average yield which more than offset the increase in the average balance.  Average noninterest bearing demand deposits increased $12.6 million, or 2.3%, during the six months ended June 30, 2013.  The latter three categories, which are considered the lowest cost deposits, comprised 73.8% of total average deposits during the six months ended June 30, 2013 compared to 64.6% during the same period in 2012.  The increase in our average total deposits is primarily the result of an increase in public fund deposits and deposit growth due to market penetration.

All of the long-term brokered CDs, except for one $5.0 million CD, have short-term calls that we control.  When we utilize long-term callable brokered CDs it is because the brokered CDs better match overall ALCO objectives at the time of issuance by protecting us with fixed rates should interest rates increase, while providing us options to call the funding should interest rates decrease.  At June 30, 2013, we had $36.0 million in brokered CDs that represented 1.4% of deposits, all with maturities of less than seven years. At December 31, 2012, we had $19.5 million in brokered CDs that represented 0.8% of deposits, all with maturities of less than five years.

Average short-term interest bearing liabilities, consisting primarily of FHLB advances, federal funds purchased and repurchase agreements, were $152.1 million, a decrease of $159.9 million, or 51.2%, for the six months ended June 30, 2013 when compared to the same period in 2012.  Interest expense associated with short-term interest bearing liabilities decreased $1.7 million, or 50.7%, while the average rate paid increased three basis points to 2.17% for the six months ended June 30, 2013, when compared to 2.14% for the same period in 2012.  For the three months ended June 30, 2013, average short-term interest bearing liabilities decreased $217.3 million, or 59.2%, when compared to the same period in 2012.  Interest expense associated with short-term interest bearing liabilities decreased $1.3 million, or 77.6%, and the average rate paid decreased to 1.04% for the three months ended June 30, 2013, when compared to 1.90% for the same period in 2012. The decrease in the interest expense was due to a decrease in the average balance and average rate paid.

Average long-term interest bearing liabilities consisting of FHLB advances increased $108.8 million, or 37.6%, during the six months ended June 30, 2013 to $398.6 million, as compared to $289.7 million for the six months ended June 30, 2012.  Interest expense associated with long-term FHLB advances decreased $465,000, or 13.4%, and the average rate paid decreased 89 basis points for the six months ended June 30, 2013, when compared to the same period in 2012.  For the three months ended June 30, 2013, long-term interest bearing liabilities increased $117.3 million, or 37.6%, when compared to the same period in 2012.  Interest expense associated with long-term FHLB advances increased $19,000, or 1.2%, while the average rate paid decreased to 1.49% for the three months ended June 30, 2013, when compared to 2.03% for the same period in 2012. The increase in the average long-

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term FHLB advances is due primarily to the increase in the purchase of long-term advances during the 12 months ended June 30, 2013, when compared to the same period in 2012. In addition, as $50 million of the $200 million par in long-term advance commitments from the FHLB expired, long-term advances at rates below the advance commitment rates that expired were obtained.  During 2010 and 2011, we entered into the option to fund between one and a half years and two years forward from the advance commitment date, $200 million par in long-term advance commitments from the FHLB at the FHLB rates on the date the option was purchased.  During the first quarter of 2013, the remaining $50 million par of long-term commitments expired unexercised.  In order to obtain these commitments from the FHLB, we paid fees of $10.95 million.  During 2012, the value of the FHLB advance option fees became further impaired resulting in a total charge of $2.03 million in 2012 which resulted in the FHLB advance option fees being fully impaired and completely written down.

Average long-term debt, consisting of our junior subordinated debentures was $60.3 million for the three and six months ended June 30, 2013 and 2012.  Interest expense associated with long-term debt decreased $931,000, or 56.3%, to $724,000 for the six months ended June 30, 2013, when compared to $1.7 million for the same period in 2012, as a result of a decrease in the average yield of 310 basis points during the six months ended June 30, 2013, when compared to the same period in 2012.  Interest expense was $362,000 for the three months ended June 30, 2013, a decrease of $463,000, or 56.1%, when compared to the same period in 2012, as a result of a decrease in the average yield of 309 basis points.  The interest rate on the $20.6 million of long-term debentures issued to Southside Statutory Trust III adjusts quarterly at a rate equal to three-month LIBOR plus 294 basis points.  The interest rate on the $23.2 million of long-term debentures issued to Southside Statutory Trust IV adjusts quarterly at a rate equal to three-month LIBOR plus 130 basis points. The interest rate on the $12.9 million of long-term debentures issued to Southside Statutory Trust V adjusts quarterly at a rate equal to three-month LIBOR plus 225 basis points.  The interest rate on the $3.6 million of long-term debentures issued to Magnolia Trust Company I, adjusts quarterly at a rate equal to three-month LIBOR plus 180 basis points.

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RESULTS OF OPERATIONS

The analysis below shows average interest earning assets and interest bearing liabilities together with the average yield on the interest earning assets and the average cost of the interest bearing liabilities.
 
 
 
AVERAGE BALANCES AND YIELDS
 
 
 
 
 
 
 
(dollars in thousands)
 
 
 
 
 
 
 
 
 
(unaudited)
 
 
 
 
 
 
 
 
 
Six Months Ended
 
 
 
 
 
June 30, 2013 (1)
 
June 30, 2012
 
AVG
 
 
 
AVG
 
AVG
 
 
 
AVG
 
BALANCE
 
INTEREST
 
YIELD
 
BALANCE
 
INTEREST
 
YIELD
ASSETS
 
 
 
 
 
 
 
 
 
 
 
INTEREST EARNING ASSETS:
 
 
 
 
 
 
 
 
 
 
 
Loans (2)(3)
$
1,277,991

 
$
37,950

 
5.99
%
 
$
1,137,397

 
$
36,132

 
6.39
%
Loans Held For Sale
1,786

 
28

 
3.16
%
 
1,637

 
31

 
3.81
%
Securities:
 
 
 
 
 
 
 
 
 
 
 
Investment Securities (Taxable)(5)
64,835

 
533

 
1.66
%
 
5,167

 
51

 
1.98
%
Investment Securities (Tax-Exempt)(4)(5)
603,286

 
15,392

 
5.15
%
 
278,435

 
8,473

 
6.12
%
Mortgage-backed and Related Securities (5)
1,038,261

 
8,616

 
1.67
%
 
1,592,499

 
21,035

 
2.66
%
Total Securities
1,706,382

 
24,541

 
2.90
%
 
1,876,101

 
29,559

 
3.17
%
    FHLB stock and other investments, at cost
27,999

 
99

 
0.71
%
 
34,553

 
133

 
0.77
%
Interest Earning Deposits
56,369

 
78

 
0.28
%
 
14,750

 
15

 
0.20
%
Total Interest Earning Assets
3,070,527

 
62,696

 
4.12
%
 
3,064,438

 
65,870

 
4.32
%
NONINTEREST EARNING ASSETS:
 
 
 
 
 
 
 
 
 
 
 
Cash and Due From Banks
46,485

 
 
 
 
 
42,004

 
 
 
 
Bank Premises and Equipment
50,171

 
 
 
 
 
50,551

 
 
 
 
Other Assets
127,715

 
 
 
 
 
167,295

 
 
 
 
Less:  Allowance for Loan Loss
(19,044
)
 
 
 
 
 
(19,501
)
 
 
 
 
Total Assets
$
3,275,854

 
 
 
 
 
$
3,304,787

 
 
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
 
 
 
 
 
 
 
 
INTEREST BEARING LIABILITIES:
 
 
 
 
 
 
 
 
 
 
 
Savings Deposits
$
106,444

 
71

 
0.13
%
 
$
94,647

 
73

 
0.16
%
Time Deposits
618,157

 
2,280

 
0.74
%
 
821,752

 
4,371

 
1.07
%
Interest Bearing Demand Deposits
1,070,951

 
1,720

 
0.32
%
 
859,343

 
1,716

 
0.40
%
Total Interest Bearing Deposits
1,795,552

 
4,071

 
0.46
%
 
1,775,742

 
6,160

 
0.70
%
Short-term Interest Bearing Liabilities
152,090

 
1,639

 
2.17
%
 
311,948

 
3,326

 
2.14
%
Long-term Interest Bearing Liabilities – FHLB Dallas
398,570

 
3,011

 
1.52
%
 
289,743

 
3,476

 
2.41
%
Long-term Debt (6)
60,311

 
724

 
2.42
%
 
60,311

 
1,655

 
5.52
%
Total Interest Bearing Liabilities
2,406,523

 
9,445

 
0.79
%
 
2,437,744

 
14,617

 
1.21
%
NONINTEREST BEARING LIABILITIES:
 
 
 
 
 
 
 
 
 
 
 
Demand Deposits
559,762

 
 
 
 
 
547,150

 
 
 
 
Other Liabilities
51,087

 
 
 
 
 
53,926

 
 
 
 
Total Liabilities
3,017,372

 
 
 
 
 
3,038,820

 
 
 
 
SHAREHOLDERS’ EQUITY
258,482

 
 
 
 
 
265,967

 
 
 
 
Total Liabilities and Shareholders’ Equity
$
3,275,854

 
 
 
 
 
$
3,304,787

 
 
 
 
NET INTEREST INCOME
 
 
$
53,251

 
 
 
 
 
$
51,253

 
 
NET INTEREST MARGIN ON AVERAGE EARNING ASSETS
 
 
 
 
3.50
%
 
 
 
 
 
3.36
%
NET INTEREST SPREAD
 
 
 
 
3.33
%
 
 
 
 
 
3.11
%

(1)
Restated
(2)
Interest on loans includes fees on loans that are not material in amount.
(3)
Interest income includes taxable-equivalent adjustments of $1,923 and $1,867 for the six months ended June 30, 2013 and 2012 , respectively.
(4)
Interest income includes taxable-equivalent adjustments of $4,997 and $2,845 for the six months ended June 30, 2013 and 2012 , respectively.
(5)
For the purpose of calculating the average yield, the average balance of securities is presented at historical cost.
(6)
Represents junior subordinated debentures issued by us to Southside Statutory Trust III, IV, and V in connection with the issuance by Southside Statutory Trust III of $20 million of trust preferred securities, Southside Statutory Trust IV of $22.5 million of trust preferred securities, Southside Statutory Trust V of $12.5 million of trust preferred securities and junior subordinated debentures issued by FWBS to Magnolia Trust Company I in connection with the issuance by Magnolia Trust Company I of $3.5 million of trust preferred securities.

Note: As of June 30, 2013 and 2012 , loans totaling $8,179 and $10,077 , respectively, were on nonaccrual status. The policy is to reverse previously accrued but unpaid interest on nonaccrual loans; thereafter, interest income is recorded to the extent received when appropriate.

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AVERAGE BALANCES AND YIELDS
 
 
 
 
 
 
 
(dollars in thousands)
 
 
 
 
 
 
 
 
 
(unaudited)
 
 
 
 
 
 
 
 
 
Three Months Ended
 
 
 
 
 
June 30, 2013 (1)
 
June 30, 2012
 
AVG
 
 
 
AVG
 
AVG
 
 
 
AVG
 
BALANCE
 
INTEREST
 
YIELD
 
BALANCE
 
INTEREST
 
YIELD
ASSETS
 
 
 
 
 
 
 
 
 
 
 
INTEREST EARNING ASSETS:
 
 
 
 
 
 
 
 
 
 
 
Loans (2)(3)
$
1,288,494

 
$
19,322

 
6.01
%
 
$
1,165,141

 
$
18,442

 
6.37
%
Loans Held For Sale
1,311

 
12

 
3.67
%
 
1,568

 
14

 
3.59
%
Securities:
 
 
 
 
 
 
 
 
 
 
 
Investment Securities (Taxable) (5)
39,719

 
169

 
1.71
%
 
5,660

 
20

 
1.42
%
Investment Securities (Tax-Exempt)(4)(5)
692,237

 
8,720

 
5.05
%
 
307,465

 
4,483

 
5.86
%
Mortgage-backed and Related Securities (5)
1,036,866

 
4,680

 
1.81
%
 
1,606,106

 
8,872

 
2.22
%
Total Securities
1,768,822

 
13,569

 
3.08
%
 
1,919,231

 
13,375

 
2.80
%
FHLB stock and other investments, at cost
29,074

 
34

 
0.47
%
 
35,202

 
54

 
0.62
%
Interest Earning Deposits
46,362

 
35

 
0.30
%
 
8,226

 
9

 
0.44
%
Total Interest Earning Assets
3,134,063

 
32,972

 
4.22
%
 
3,129,368

 
31,894

 
4.10
%
NONINTEREST EARNING ASSETS:
 
 
 
 
 
 
 
 
 
 
 
Cash and Due From Banks
44,334

 
 
 
 
 
41,112

 
 
 
 
Bank Premises and Equipment
50,214

 
 
 
 
 
50,509

 
 
 
 
Other Assets
125,881

 
 
 
 
 
167,246

 
 
 
 
Less:  Allowance for Loan Loss
(18,095
)
 
 
 
 
 
(19,945
)
 
 
 
 
Total Assets
$
3,336,397

 
 
 
 
 
$
3,368,290

 
 
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
 
 
 
 
 
 
 
 
INTEREST BEARING LIABILITIES:
 
 
 
 
 
 
 
 
 
 
 
Savings Deposits
$
108,446

 
35

 
0.13
%
 
$
96,527

 
36

 
0.15
%
Time Deposits
614,115

 
1,118

 
0.73
%
 
782,371

 
1,894

 
0.97
%
Interest Bearing Demand Deposits
1,080,605

 
848

 
0.31
%
 
863,308

 
835

 
0.39
%
Total Interest Bearing Deposits
1,803,166

 
2,001

 
0.45
%
 
1,742,206

 
2,765

 
0.64
%
Short-term Interest Bearing Liabilities
149,913

 
389

 
1.04
%
 
367,195

 
1,734

 
1.90
%
Long-term Interest Bearing Liabilities – FHLB Dallas
428,800

 
1,592

 
1.49
%
 
311,550

 
1,573

 
2.03
%
Long-term Debt (6)
60,311

 
362

 
2.41
%
 
60,311

 
825

 
5.50
%
Total Interest Bearing Liabilities
2,442,190

 
4,344

 
0.71
%
 
2,481,262

 
6,897

 
1.12
%
NONINTEREST BEARING LIABILITIES:
 
 
 
 
 
 
 
 
 
 
 
Demand Deposits
580,572

 
 
 
 
 
565,344

 
 
 
 
Other Liabilities
55,120

 
 
 
 
 
55,593

 
 
 
 
Total Liabilities
3,077,882

 
 
 
 
 
3,102,199

 
 
 
 
SHAREHOLDERS’ EQUITY
258,515

 
 
 
 
 
266,091

 
 
 
 
Total Liabilities and Shareholders’ Equity
$
3,336,397

 
 
 
 
 
$
3,368,290

 
 
 
 
NET INTEREST INCOME
 
 
$
28,628

 
 
 
 
 
$
24,997

 
 
NET INTEREST MARGIN ON AVERAGE EARNING ASSETS
 
 
 
 
3.66
%
 
 
 
 
 
3.21
%
NET INTEREST SPREAD
 
 
 
 
3.51
%
 
 
 
 
 
2.98
%

(1)
Restated
(2)
Interest on loans includes fees on loans that are not material in amount.
(3)
Interest income includes taxable-equivalent adjustments of $944 and $930 for the three months ended June 30, 2013 and 2012 , respectively.
(4)
Interest income includes taxable-equivalent adjustments of $2,813 and $1,522 for the three months ended June 30, 2013 and 2012 , respectively.
(5)
For the purpose of calculating the average yield, the average balance of securities is presented at historical cost.
(6)
Represents junior subordinated debentures issued by us to Southside Statutory Trust III, IV, and V in connection with the issuance by Southside Statutory Trust III of $20 million of trust preferred securities, Southside Statutory Trust IV of $22.5 million of trust preferred securities, Southside Statutory Trust V of $12.5 million of trust preferred securities and junior subordinated debentures issued by FWBS to Magnolia Trust Company I in connection with the issuance by Magnolia Trust Company I of $3.5 million of trust preferred securities.

Note: As of June 30, 2013 and 2012 , loans totaling $8,179 and $10,077 , respectively, were on nonaccrual status.  The policy is to reverse previously accrued but unpaid interest on nonaccrual loans; thereafter, interest income is recorded to the extent received when appropriate.

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Noninterest Income (2013 Restated)

Noninterest income consists of revenue generated from a broad range of financial services and activities including deposit related fee based services such as ATM, overdraft, and check processing fees.  In addition, we earn income from the sale of loans and securities, trust services, bank owned life insurance (“BOLI”), brokerage services, and other fee generating programs that we either provide or in which we participate.

Noninterest income was $11.1 million and $21.3 million for the three and six months ended June 30, 2013 , respectively, compared to $8.1 million and $18.9 million for the same periods in 2012 , an increase of $3.0 million , or 37.6% , and $2.5 million , or 13.1% , respectively.  The primary reason for the increase in noninterest income for the three months ended June 30, 2013 , was due to the increase in gain on sale of securities available for sale and a decrease in the FHLB advance option impairment charges when compared to the same period in 2012 .  The primary reason for the increase in noninterest income for the six months ended June 30, 2013 , was due to the decrease in the FHLB advance option impairment charges when compared to the same period in 2012 . During the six months ended June 30, 2013 and 2012, we had gain on sale of AFS securities of $9.3 million .   Gain on sale of AFS securities for the three months ended June 30, 2013 was $5.0 million , compared to $3.3 million for the same period in 2012 . The fair value of the AFS securities portfolio at June 30, 2013 was $1.31 billion with a net unrealized loss on that date of $11.5 million .  The net unrealized loss is comprised of $22.9 million in unrealized gains and $34.4 million in unrealized losses.  The fair value of the HTM securities portfolio at June 30, 2013 was $530.1 million with a net unrealized loss on that date of $13.4 million .  The net unrealized loss is comprised of $5.2 million in unrealized gains and approximately $18.7 million in unrealized losses.  During the six months ended June 30, 2013 , we pro-actively managed the investment portfolio which included restructuring a portion of our investment portfolio.  During the quarter ended June 30, 2013 , we sold long duration municipal securities, lower coupon municipal securities, U.S. Agency Commercial MBS, U.S. Agency MBS and to a lesser extent, U.S. Agency debentures and taxable municipals. The sale of these securities resulted in a gain on the sale of available for sale securities of $5.0 million.  There can be no assurance that the level of security gains reported during the six months ended June 30, 2013 , will continue in future periods.

For the three and six months ended June 30, 2012 , the value of the FHLB advance options fees became further impaired resulting in a $1.4 million and $1.8 million impairment charge, respectively. At June 30, 2012 , the carrying value of the FHLB advance option fees on the balance sheet was $195,000. At December 31, 2012, the value of the FHLB advance option fees was completely impaired and written down.

Gain on sale of loans decrease d $57,000 , or 19.1% , for the three months ended June 30, 2013 and increase d $131,000 , or 30.5% , for the six months ended June 30, 2013 when compared to the same periods in 2012 .  The increase for the six months ended June 30, 2013 was due primarily to an increase in the dollar amount of loans sold and the related servicing release and secondary market fees.

Other income decrease d $170,000 , or 15.1% , and $390,000 , or 17.5% , for the three and six months ended June 30, 2013 , respectively, when compared to the same periods in 2012 as a result of decrease s in the credit life income, deluxe income and trading income.

Noninterest Expense

We incur numerous types of noninterest expenses associated with the operation of our various business activities, the largest of which are salaries and employee benefits.  In addition, we incur numerous other expenses, the largest of which are detailed in the consolidated statements of income.

Noninterest expense was $21.2 million and $41.5 million for the three and six months ended June 30, 2013, respectively, compared to $19.1 million and $37.6 million for the same periods in 2012, respectively, representing an increase of $2.1 million, or 10.8%, and $3.9 million, or 10.3%, for the three and six months ended June 30, 2013, respectively.

Salaries and employee benefits expense increased $1.3 million, or 10.4%, and $2.6 million, or 11.0%, during the three and six months ended June 30, 2013, respectively, when compared to the same periods in 2012.  The increase for the three and six months ended June 30, 2013 was primarily the result of increases in the number of personnel over the prior year, share-based compensation associated with the 2012 awards, retirement expense, and increased health insurance expense.

Direct salary expense and payroll taxes increased $930,000, or 9.2%, and $2.0 million, or 10.0%, during the three and six months ended June 30, 2013, respectively, when compared to the same periods in 2012.


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Retirement expense, included in salary and benefits, increased $349,000, or 33.7%, and $439,000, or 20.3%, for the three and six months ended June 30, 2013, when compared to the same periods in 2012.  The increase was primarily related to the increase in the defined benefit and restoration plans.  The defined benefit and restoration plan increased primarily due to the changes in the actuarial assumptions used to determine net periodic pension costs for 2013 when compared to 2012.  Specifically, the assumed long-term rate of return was 7.25% and the assumed discount rate decreased to 4.08%.  We will continue to evaluate the assumed long-term rate of return and the discount rate to determine if either should be changed in the future.  If either of these assumptions decreased, the cost and funding required for the retirement plan could increase.

Health and life insurance expense, included in salary and benefits, decreased $20,000, or 1.9%, for the three months ended June 30, 2013 and increased $199,000, or 11.3% for the six months ended June 30, 2013, when compared to the same periods in 2012.  The increase for the six months ended June 30, 2013 is due to increases in total personnel and additional claims cost.  We have a self-insured health plan which is supplemented with stop loss insurance policies.  Health insurance costs are rising nationwide and these costs may continue to increase during the remainder of 2013.

ATM and debit card expense increased $16,000, or 5.6% and $118,000, or 20.8%, for the three and six months ended June 30, 2013, when compared to the same periods in 2012 due to an increase in processing expenses and a nonrecurring transaction expense of $80,000.

Supplies decreased $53,000, or 23.9%, for the three months ended June 30, 2013 and increased $38,000, or 10.0% for the six months ended June 30, 2013, when compared to the same periods in 2012. The increase for the six months ended June 30, 2013 is primarily due to a credit recorded in the first three months of 2012 associated with the outsourcing of the purchase and delivery of our supplies.

Telephone and communications decreased $61,000, or 13.7% and $16,000, or 1.9%, for the three and six months ended June 30, 2013, respectively, as compared to the same periods in 2012 due to credits received from a vendor.

FHLB prepayment fees were $1.0 million, during the three and six months ended June 30, 2013 as a result of the prepayment of $90.2 million of FHLB advances during the second quarter.

Income Taxes (2013 Restated)

Pre-tax income for the three and six months ended June 30, 2013 was $12.8 million and $23.7 million , respectively, compared to $9.3 million and $22.6 million , for the same periods in 2012 .  Income tax expense was $1.7 million and $3.6 million for the three and six months ended June 30, 2013 , respectively, compared to $1.6 million and $4.7 million for the three and six months ended June 30, 2012 , respectively.  The effective tax rate as a percentage of pre-tax income was 13.4% and 15.0% for the three and six months ended June 30, 2013 , respectively, compared to 17.2% and 20.8% , for the same periods in 2012 .  The decrease in the effective tax rate for the three and six months ended June 30, 2013 was due to an increase in tax-exempt income as a percentage of taxable income, as compared to the same period in 2012 . The net deferred assets totaled $21.5 million at June 30, 2013 , as compared to $4.1 million at December 31, 2012.

Capital Resources (2013 Restated)

Our total shareholders' equity at June 30, 2013 , was $236.1 million , representing a decrease of 8.4% , or $21.6 million from December 31, 2012 and represented 7.0% of total assets at June 30, 2013 , compared to 8.0% of total assets at December 31, 2012 .

Increases to our shareholders’ equity consisted of net income of $20.1 million , the issuance of $628,000 in common stock ( 28,529 shares) through our dividend reinvestment plan and $373,000 of stock compensation expense, which was more than offset by a decrease in accumulated other comprehensive income of $33.9 million , the repurchase of $1.9 million of common stock, and $7.0 million in cash dividends paid.

On March 28, 2013, our board of directors declared a 5% stock dividend to common stock shareholders of record as of April 18, 2013, which was paid on May 9, 2013.

Under the Federal Reserve Board's risk-based capital guidelines for bank holding companies, the minimum ratio of total capital to risk-adjusted assets (including certain off-balance sheet items, such as standby letters of credit) is currently 8%.  The minimum Tier 1 capital to risk-adjusted assets is 4%.  Our $20 million, $22.5 million, $12.5 million and $3.5 million of trust preferred securities issued by our subsidiaries, Southside Statutory Trust III, IV, V and Magnolia Trust Company I, respectively, are currently considered Tier 1 capital by the Federal Reserve Board. The Federal Reserve Board also requires bank holding companies to comply with the minimum leverage ratio guidelines.  The leverage ratio is the ratio of bank holding company's Tier 1 capital to

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its total consolidated quarterly average assets, less goodwill and certain other intangible assets.  The guidelines require a minimum leverage ratio of 4% for bank holding companies that meet certain specified criteria.  Failure to meet minimum capital requirements could result in certain mandatory and possibly additional discretionary actions by our regulators that, if undertaken, could have a direct material effect on our financial statements.  Management believes that, as of June 30, 2013, we met all capital adequacy requirements to which we were subject.

The Federal Deposit Insurance Act requires bank regulatory agencies to take "prompt corrective action" with respect to FDIC-insured depository institutions that do not meet minimum capital requirements.  A depository institution's treatment for purposes of the prompt corrective action provisions will depend on how its capital levels compare to various capital measures and certain other factors, as established by regulation.  Prompt corrective action and other discretionary actions could have a direct material effect on our financial statements.

It is management's intention to maintain our capital at a level acceptable to all regulatory authorities and future dividend payments will be determined accordingly.  Regulatory authorities require that any dividend payments made by either us or the Bank, not exceed earnings for that year.  Shareholders should not anticipate a continuation of the cash dividend simply because of the existence of a dividend reinvestment program.  The payment of dividends will depend upon future earnings, our financial condition, and other related factors including the discretion of the board of directors.

To be categorized as well capitalized we must maintain minimum Total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the following table:
 
Actual
 
For Capital
Adequacy Purposes
 
To Be Well Capitalized
Under Prompt
Corrective Actions
Provisions
 
Amount
 
Ratio
 
Amount
 
Ratio
 
Amount
 
Ratio
As of June 30, 2013:
(dollars in thousands)
Total Capital (to Risk Weighted Assets)
 
 
 
 
 
 
 
 
 
 
 
Consolidated
$
321,619

 
21.13
%
 
$
121,788

 
8.00
%
 
N/A

 
N/A

Bank Only
$
318,210

 
20.91
%
 
$
121,718

 
8.00
%
 
$
152,148

 
10.00
%
Tier 1 Capital (to Risk Weighted Assets)
 

 
 

 
 

 
 

 
 

 
 

Consolidated
$
303,237

 
19.92
%
 
$
60,894

 
4.00
%
 
N/A

 
N/A

Bank Only
$
299,828

 
19.71
%
 
$
60,859

 
4.00
%
 
$
91,289

 
6.00
%
Tier 1 Capital (to Average Assets) (1)
 

 
 

 
 

 
 

 
 

 
 

Consolidated
$
303,237

 
9.24
%
 
$
131,242

 
4.00
%
 
N/A

 
N/A

Bank Only
$
299,828

 
9.14
%
 
$
131,149

 
4.00
%
 
$
163,937

 
5.00
%
As of December 31, 2012:
 
Total Capital (to Risk Weighted Assets)
 

 
 

 
 

 
 

 
 

 
 

Consolidated
$
308,133

 
22.42
%
 
$
109,962

 
8.00
%
 
N/A

 
N/A

Bank Only
$
300,196

 
21.86
%
 
$
109,852

 
8.00
%
 
$
137,315

 
10.00
%
Tier 1 Capital (to Risk Weighted Assets)
 

 
 

 
 

 
 

 
 

 
 

Consolidated
$
290,873

 
21.16
%
 
$
54,981

 
4.00
%
 
N/A

 
N/A

Bank Only
$
282,936

 
20.60
%
 
$
54,926

 
4.00
%
 
$
82,389

 
6.00
%
Tier 1 Capital (to Average Assets) (1)
 

 
 

 
 

 
 

 
 

 
 

Consolidated
$
290,873

 
9.11
%
 
$
127,698

 
4.00
%
 
N/A

 
N/A

Bank Only
$
282,936

 
8.87
%
 
$
127,531

 
4.00
%
 
$
159,413

 
5.00
%

(1)
Refers to quarterly average assets as calculated by bank regulatory agencies.
Basel III Capital Rules. In July 2013, the Federal Reserve, our primary federal regulator, published final rules (the “Basel III Capital Rules”) establishing a new comprehensive capital framework for U.S. banking organizations. The rules implement the Basel Committee's December 2010 framework known as “Basel III” for strengthening international capital standards as well as certain provisions of the Dodd-Frank Act. The Basel III Capital Rules substantially revise the risk-based capital requirements applicable to bank holding companies and depository institutions, including Southside Bancshares and Southside Bank, compared to the current U.S. risk-based capital rules. The Basel III Capital Rules define the components of capital and address other issues

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affecting the numerator in banking institutions' regulatory capital ratios. The Basel III Capital Rules also address risk weights and other issues affecting the denominator in banking institutions' regulatory capital ratios and replace the existing risk-weighting approach, which was derived from the Basel I capital accords of the Basel Committee, with a more risk-sensitive approach based, in part, on the standardized approach in the Basel Committee's 2004 “Basel II” capital accords. The Basel III Capital Rules also implement the requirements of Section 939A of the Dodd-Frank Act to remove references to credit ratings from the federal banking agencies' rules. The Basel III Capital Rules are effective for Southside Bancshares and Southside Bank on January 1, 2015 (subject to a phase-in period).
The Basel III Capital Rules, among other things, (i) introduce a new capital measure called “Common Equity Tier 1” (“CET1”), (ii) specify that Tier 1 capital consist of CET1 and “Additional Tier 1 capital” instruments meeting specified requirements, (iii) define CET1 narrowly by requiring that most deductions/adjustments to regulatory capital measures be made to CET1 and not to the other components of capital and (iv) expand the scope of the deductions/adjustments as compared to existing regulations.
 
When fully phased in on January 1, 2019, the Basel III Capital Rules will require Southside Bancshares and Southside Bank to maintain (i) a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7% upon full implementation), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of Total capital (that is, Tier 1 plus Tier 2) to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation) and (iv) a minimum leverage ratio of 4%, calculated as the ratio of Tier 1 capital to average assets (as compared to a current minimum leverage ratio of 3% for banking organizations that either have the highest supervisory rating or have implemented the appropriate federal regulatory authority's risk-adjusted measure for market risk).
The Basel III Capital Rules also provide for a “countercyclical capital buffer” that is applicable to only certain covered institutions and is not expected to have any current applicability to Southside Bancshares and Southside Bank.
The aforementioned capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the conservation buffer (or below the combined capital conservation buffer and countercyclical capital buffer, when the latter is applied) will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall.
Under the Basel III Capital Rules, the initial minimum capital ratios as of January 1, 2015 will be as follows:
4.5% CET1 to risk-weighted assets.
6.0% Tier 1 capital to risk-weighted assets.
8.0% Total capital to risk-weighted assets.

The Basel III Capital Rules provide for a number of deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing rights, deferred tax assets dependent upon future taxable income and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1. Currently, the effects of accumulated other comprehensive income items included in capital are excluded for the purposes of determining regulatory capital ratios. Under the Basel III Capital Rules, the effects of certain accumulated other comprehensive items are not excluded; however, non-advanced approaches banking organizations, including Southside Bancshares and Southside Bank, may make a one-time permanent election to continue to exclude these items. Southside Bancshares and Southside Bank expect to make this election in order to avoid significant variations in the level of capital depending upon the impact of interest rate fluctuations on the fair value of our securities portfolio. The Basel III Capital Rules provide that depository holding companies with less than $15 billion in total assets as of December 31, 2009, such as Southside Bancshares, may permanently include trust preferred securities and certain other non-qualifying instruments issued and included in Tier 1 or Tier 2 capital before May 19, 2010 in additional Tier 1 (subject to a maximum of 25% of Tier 1 capital) or Tier 2 capital until maturity or redemption.
Implementation of the deductions and other adjustments to CET1 will begin on January 1, 2015 and will be phased-in over a four-year period (beginning at 40% on January 1, 2015 and an additional 20% per year thereafter). The implementation of the capital conservation buffer will begin on January 1, 2016 at the 0.625% level and be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019).

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With respect to insured depository institutions, such as Southside Bank, the Basel III Capital Rules also revise the “prompt corrective action” regulations pursuant to Section 38 of the Federal Deposit Insurance Act, by (i) introducing a CET1 ratio requirement at each level (other than critically undercapitalized), with the required CET1 ratio being 6.5% for well-capitalized status; (ii) increasing the minimum Tier 1 capital ratio requirement for each category (other than critically undercapitalized), with the minimum Tier 1 capital ratio for well-capitalized status being 8% (as compared to the current 6%); and (iii) eliminating the current provision that provides that a bank with a composite supervisory rating of 1 may have a 3% leverage ratio and still be adequately capitalized. The Basel III Capital Rules do not change the total risk-based capital requirement for any prompt corrective action category.
 
The Basel III Capital Rules prescribe a standardized approach for risk weightings that expand the risk-weighting categories from the current four categories under the Basel I framework (0%, 20%, 50% and 100%) to a much larger and more risk-sensitive number of categories, depending on the nature of the assets, generally ranging from 0% for U.S. government and agency securities, to 600% for certain equity exposures, and resulting in higher risk weights for a variety of asset categories. Specific changes to current rules impacting our determination of risk-weighted assets include, among other things:

Applying a 150% risk weight instead of a 100% risk weight for certain high volatility commercial real estate acquisition, development and construction loans.
Assigning a 150% risk weight to exposures (other than residential mortgage exposures) that are 90 days past due.
Providing for a 20% credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancelable (currently set at 0%).
Providing for a risk weight, generally not less than 20% with certain exceptions, for securities lending transactions based on the risk weight category of the underlying collateral securing the transaction.
Providing for a 100% risk weight for claims on securities firms.
Eliminating the current 50% cap on the risk weight for OTC derivatives.

In addition, the Basel III Capital Rules provide more advantageous risk weights for derivatives and repurchase-style transactions cleared through a qualifying central counterparty and increase the scope of eligible guarantors and eligible collateral for purposes of credit risk mitigation.
Management believes that, as of June 30, 2013, Southside Bancshares and Southside Bank would meet all capital adequacy requirements under the Basel III Capital Rules on a fully phased-in basis as if such requirements were currently in effect. The Basel III Capital Rules adopted in July 2013 do not address the proposed liquidity coverage ratio test and net stable funding ratio test called for by the Basel III liquidity framework. See the section captioned “Supervision and Regulation” in Item 1. Business of our 2012 Form 10-K for more information on these topics.

The table below summarizes our key equity ratios for the three and six months ended June 30, 2013 and 2012 :
 
Six Months Ended
June 30,
 
2013
 
2012
Return on Average Assets
1.24
%
 
1.09
%
Return on Average Shareholders' Equity
15.69

 
13.51

Dividend Payout Ratio – Basic
35.40

 
38.78

Dividend Payout Ratio – Diluted
35.71

 
38.78

Average Shareholders' Equity to Average Total Assets
7.89

 
8.05

 
Three Months Ended
June 30,
 
2013
 
2012
Return on Average Assets
1.33
%
 
0.92
%
Return on Average Shareholders' Equity
17.17

 
11.68

Dividend Payout Ratio – Basic
32.26

 
47.62

Dividend Payout Ratio – Diluted
32.26

 
47.62

Average Shareholders' Equity to Average Total Assets
7.75

 
7.90


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Liquidity and Interest Rate Sensitivity

Liquidity management involves our ability to convert assets to cash with a minimum of loss to enable us to meet our obligations to our customers at any time.  This means addressing (1) the immediate cash withdrawal requirements of depositors and other funds providers; (2) the funding requirements of all lines and letters of credit; and (3) the short-term credit needs of customers.  Liquidity is provided by short-term investments that can be readily liquidated with a minimum risk of loss.  Cash, interest earning deposits, federal funds sold and short-term investments with maturities or repricing characteristics of one year or less continue to be a substantial percentage of total assets.  At June 30, 2013, these investments were 11.3% of total assets as compared with 18.6% for December 31, 2012 and 18.8% for June 30, 2012.  The decrease to 11.3% at June 30, 2013 is primarily reflective of changes in the investment portfolio.  Liquidity is further provided through the matching, by time period, of rate sensitive interest earning assets with rate sensitive interest bearing liabilities.  Southside Bank has three lines of credit for the purchase of overnight federal funds at prevailing rates.  One $25.0 million and two $15.0 million unsecured lines of credit have been established with Frost Bank, Comerica Bank and TIB - The Independent Bankers Bank, respectively.  There were no federal funds purchased at June 30, 2013.  Southside Bank has a $5.0 million line of credit with Frost Bank to be used to issue letters of credit.  At June 30, 2013, the amount of additional funding Southside Bank could obtain from FHLB using unpledged securities at FHLB was approximately $196.2 million, net of FHLB stock purchases required.  Southside Bank obtained no letters of credit from FHLB as collateral for a portion of its public fund deposits.

Interest rate sensitivity management seeks to avoid fluctuating net interest margins and to enhance consistent growth of net interest income through periods of changing interest rates.  The ALCO closely monitors various liquidity ratios, interest rate spreads and margins.  The ALCO performs interest rate simulation tests that apply various interest rate scenarios including immediate shocks and market value of portfolio equity (“MVPE”) with interest rates immediately shocked plus and minus 200 basis points to assist in determining our overall interest rate risk and adequacy of the liquidity position.  In addition, the ALCO utilizes a simulation model to determine the impact on net interest income of several different interest rate scenarios.  By utilizing this technology, we can determine changes that need to be made to the asset and liability mixes to minimize the change in net interest income under these various interest rate scenarios.

Composition of Loans

One of our main objectives is to seek attractive lending opportunities in Texas, primarily in the counties in which we operate.  Refer to “Part I - Item 1. Business - Market Area” in our Annual Report on Form 10-K for the year ended December 31, 2012 for a discussion of our primary market area and the geographic concentration of our loan portfolio as of December 31, 2012.  There were no substantial changes in these concentrations during the six months ended June 30, 2013.  Substantially all of our loan originations are made to borrowers who live in and conduct business in our primary market area, with the exception of municipal loans which are made almost entirely in Texas, and purchases of automobile loan portfolios throughout the United States.  Municipal loans are made to municipalities, counties, school districts and colleges primarily throughout the state of Texas.  Through SFG, we purchase portfolios of automobile loans from a variety of lenders throughout the United States.  These high yield loans represent existing subprime automobile loans with payment histories that are collateralized by new and used automobiles.  At June 30, 2013, the SFG loans totaled approximately $87.3 million.  We look forward to the possibility that our loan growth will accelerate in the future when the economy in the markets we serve improves and as we work to identify and develop additional markets and strategies that will allow us to expand our lending territory.  Total loans increased $30.5 million, or 2.4%, to $1.29 billion for the six months ended June 30, 2013 from $1.26 billion at December 31, 2012, and increased $110.2 million, or 9.3%, from $1.18 billion at June 30, 2012.  Average loans increased $140.6 million, or 12.4%, during the six months ended June 30, 2013 when compared to the same period in 2012.

Our market areas to date have not experienced the level of downturn in the economy and real estate prices that some of the harder hit areas of the country have experienced.  However, we did experience weakening conditions associated with the real estate led downturn during 2008 through 2011 and strengthened our underwriting standards, especially related to all aspects of real estate lending.  Our real estate loan portfolio does not have Alt-A or subprime mortgage exposure.



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The following table sets forth loan totals for the periods presented:
 
At
June 30,
2013
 
At
December 31,
2012
 
At
June 30,
2012
 
(in thousands)
Real Estate Loans:
 

 
 

 
 

Construction
$
123,493

 
$
113,744

 
$
105,675

1-4 Family Residential
385,241

 
368,845

 
325,720

Other
232,632

 
236,760

 
214,885

Commercial Loans
153,985

 
160,058

 
146,499

Municipal Loans
224,134

 
220,947

 
215,256

Loans to Individuals
173,944

 
162,623

 
175,165

Total Loans
$
1,293,429

 
$
1,262,977

 
$
1,183,200


Our 1-4 family residential mortgage loans increased $16.4 million, or 4.4%, to $385.2 million at June 30, 2013, from $368.8 million at December 31, 2012, and $59.5 million, or 18.3%, from $325.7 million at June 30, 2012, due to the low interest rate environment and increased activity in the Dallas-Fort Worth market.

Other real estate loans, which are comprised primarily of commercial real estate loans, decreased $4.1 million, or 1.7%, to $232.6 million at June 30, 2013, from $236.8 million at December 31, 2012, and increased $17.7 million, or 8.3%, from $214.9 million at June 30, 2012.

Construction loans increased $9.7 million, or 8.6%, to $123.5 million at June 30, 2013 from $113.7 million at December 31, 2012, and $17.8 million, or 16.9%, from $105.7 million at June 30, 2012, due to increased activity in the Austin and Dallas-Fort Worth markets.

Municipal loans increased $3.2 million, or 1.4%, to $224.1 million at June 30, 2013, from $220.9 million at December 31, 2012, and increased $8.9 million, or 4.1%, from $215.3 million at June 30, 2012.  The increase in municipal loans is due to overall market volatility related to credit markets, including municipal credits. This provided additional opportunities for us to lend to municipalities.

Commercial loans decreased $6.1 million, or 3.8%, to $154.0 million at June 30, 2013, from $160.1 million at December 31, 2012, and increased $7.5 million, or 5.1% from $146.5 million at June 30, 2012.  The decrease for the six months ended June 30, 2013 in commercial loans is reflective of decreased loan demand for this type of loan in our market area.

Loans to individuals, which includes SFG loans, increased $11.3 million, or 7.0%, to $173.9 million at June 30, 2013, from $162.6 million at December 31, 2012, and decreased $1.2 million, or 0.7%, from $175.2 million at June 30, 2012.  Most of the increase for the six months ended June 30, 2013 is due to an increase in SFG loans.  

Loan Loss Experience and Allowance for Loan Losses

The allowance for loan losses is based on the most current review of the loan portfolio and is validated by multiple processes.  First, the bank utilizes historical data to establish general reserve amounts for each class of loans.  An average three-year history of annualized net charge-offs against the average portfolio balance for that time period is utilized. The historical charge-off figure is further adjusted through qualitative factors that include general trends in past dues, nonaccruals and classified loans to more effectively and promptly react to both positive and negative movements. Second, our lenders have the primary responsibility for identifying problem loans and estimating necessary reserves based on customer financial stress and underlying collateral.  These recommendations are reviewed by the senior lender, the Special Assets department, and the Loan Review department.  Third, the Loan Review department does independent reviews of the portfolio on an annual basis.  The Loan Review department follows a board-approved annual loan review scope.  The loan review scope encompasses a number of metrics that takes into consideration the size of the loan, the type of credit extended, the seasoning of the loan along with the performance of the loan.  The loan review scope as it relates to size, focuses more on larger dollar loan relationships, typically, for example, aggregate debt of $500,000 or greater.  The loan review officer also tracks specific reserves for loans by type compared to general reserves to determine trends in comparative reserves as well as losses not reserved for prior to charge-off to determine the effectiveness of the specific reserve process.

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At each review, a subjective analysis methodology is used to grade the respective loan.  Categories of grading vary in severity from loans that do not appear to have a significant probability of loss at the time of review to loans that indicate a probability that the entire balance of the loan will be uncollectible.  If full collection of the loan balance appears unlikely at the time of review, estimates of future expected cash flows or appraisals of the collateral securing the debt are used to determine the necessary allowances.  The internal loan review department maintains a list of all loans or loan relationships that are graded as having more than the normal degree of risk associated with them.  In addition, a list of specifically reserved loans or loan relationships of $50,000 or more is updated on a quarterly basis in order to properly determine necessary allowances and keep management informed on the status of attempts to correct the deficiencies noted with respect to the loan.

For loans to individuals, the methodology associated with determining the appropriate allowance for losses on loans primarily consists of an evaluation of individual payment histories, remaining term to maturity and underlying collateral support.

Industry and our own experience indicates that a portion of our loans will become delinquent and a portion of the loans will require partial or full charge-off.  Regardless of the underwriting criteria utilized, losses may be experienced as a result of various factors beyond our control, including, among other things, changes in market conditions affecting the value of properties used as collateral for loans and problems affecting the credit of the borrower and the ability of the borrower to make payments on the loan.  Our determination of the appropriateness of the allowance for loan losses is based on various considerations, including an analysis of the risk characteristics of various classifications of loans, previous loan loss experience, specific loans which would have loan loss potential, delinquency trends, estimated fair value of the underlying collateral, current economic conditions, the views of the bank regulators (who have the authority to require additional allowances in accordance with GAAP), and geographic and industry loan concentration.

Consumer loans at SFG are reserved for based on general estimates of loss at the time of purchase for current loans.  SFG loans experiencing past due status or extension of maturity characteristics are reserved for at significantly higher levels based on the circumstances associated with each specific loan.  In general the reserves for SFG are calculated based on the past due status of the loan.  For reserve purposes, the portfolio has been segregated by past due status and by the remaining term variance from the original contract.  During repayment, loans that pay late will take longer to pay out than the original contract.  Additionally, some loans may be granted extensions for extenuating payment circumstances and evaluated for troubled debt classification.  The remaining term extensions increase the risk of collateral deterioration and accordingly, reserves are increased to recognize this risk.

New pools purchased are reserved at their estimated annual loss. Additionally, we use data mining measures to track migration within risk tranches.  Reserves are adjusted quarterly to match the migration metrics.

After all of the data in the loan portfolio is accumulated the reserve allocations are separated into various loan classes.  At June 30, 2013, the unallocated portion of the allowance for loan loss was $573,000, or 0.04%, of loans.

As of June 30, 2013, our review of the loan portfolio indicated that a loan loss allowance of $18.4 million was appropriate to cover probable losses in the portfolio.  Changes in economic and other conditions may require future adjustments to the allowance for loan losses.

For the three and six months ended June 30, 2013, loan charge-offs were $2.7 million and $5.9 million, and recoveries were $512,000 and $1.1 million, resulting in net charge-offs of $2.2 million and $4.7 million, respectively.  For the three and six months ended June 30, 2012, loan charge-offs were $2.8 million and $5.0 million, and recoveries were $718,000 and $1.4 million, resulting in net charge-offs of $2.1 million and $3.6 million, respectively.  The increase in net charge-offs for the three and six months ended June 30, 2013, was primarily related to economic conditions requiring the write-down of nonperforming loans in the current year.  The necessary provision expense was estimated at $2.0 million and $2.5 million for the three and six months ended June 30, 2013, compared to $2.2 million and $5.2 million for the comparable period in 2012.  The decrease in provision expense for the three and six months ended June 30, 2013, compared to the same period in 2012 was primarily a result of the increase in the credit quality of the loans and to a lesser extent, a decrease in nonperforming assets.

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Nonperforming Assets

Nonperforming assets consist of delinquent loans 90 days or more past due, nonaccrual loans, OREO, repossessed assets and restructured loans.  Nonaccrual loans are those loans which are 90 days or more delinquent and collection in full of both the principal and interest is in doubt.  Additionally, some loans that are not delinquent may be placed on nonaccrual status due to doubts about full collection of principal or interest.  When a loan is categorized as nonaccrual, the accrual of interest is discontinued and the accrued balance is reversed for financial statement purposes.  Restructured loans represent loans that have been renegotiated to provide a reduction or deferral of interest or principal because of deterioration in the financial position of the borrowers.  The restructuring of a loan is considered a “troubled debt restructuring” if both (i) the borrower is experiencing financial difficulties and (ii) the creditor has granted a concession. Concessions may include interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules and other actions intended to minimize potential losses. Categorization of a loan as nonperforming is not in itself a reliable indicator of potential loan loss.  Other factors, such as the value of collateral securing the loan and the financial condition of the borrower must be considered in judgments as to potential loan loss.  OREO represents real estate taken in full or partial satisfaction of debts previously contracted.  The dollar amount of OREO is based on a current evaluation of the OREO at the time it is recorded on our books, net of estimated selling costs.  Updated valuations are obtained as needed and any additional impairments are recognized.

The following tables set forth nonperforming assets for the periods presented (in thousands):

 
At
June 30,
2013
 
At
December 31,
2012
 
At
June 30,
2012
Nonaccrual loans
$
8,179

 
$
10,314

 
$
10,077

Accruing loans past due more than 90 days

 
15

 
1

Restructured loans
3,053

 
2,998

 
2,352

Other real estate owned
772

 
686

 
960

Repossessed assets
266

 
704

 
388

Total Nonperforming Assets
$
12,270

 
$
14,717

 
$
13,778


 
At
June 30,
2013
 
At
December 31,
2012
 
At
June 30,
2012
Asset Quality Ratios:
 
 
 
 
 
Nonaccruing loans to total loans
0.63
%
 
0.82
%
 
0.85
%
Allowance for loan losses to nonaccruing loans
224.60

 
199.58

 
200.40

Allowance for loan losses to nonperforming assets
149.71

 
139.87

 
146.57

Allowance for loan losses to total loans
1.42

 
1.63

 
1.71

Nonperforming assets to total assets
0.36

 
0.45

 
0.41

Net charge-offs to average loans
0.75

 
0.74

 
0.63


Total nonperforming assets at June 30, 2013 were $12.3 million, a decrease of $2.4 million, or 16.6%, from $14.7 million at December 31, 2012 and a decrease of $1.5 million, or 10.9%, from $13.8 million at June 30, 2012.  The decrease in nonperforming assets for the six months ended June 30, 2013 is primarily a result of a decrease in nonaccrual loans.

From December 31, 2012 to June 30, 2013, nonaccrual loans decreased $2.1 million, or 20.7%, to $8.2 million, and from June 30, 2012, decreased $1.9 million, or 18.8%.  Of the total nonaccrual loans at June 30, 2013, 26.8% are residential real estate loans, 8.1% are commercial real estate loans, 18.8% are commercial loans, 27.5% are loans to individuals, primarily SFG automobile loans, and 18.8% are construction loans.  Accruing loans past due more than 90 days decreased $15,000, or 100.0%, at June 30, 2013, from $15,000 at December 31, 2012 and from June 30, 2012, decreased $1,000, or 100.0%.  Restructured loans increased $55,000, or 1.8%, to $3.1 million at June 30, 2013, from $3.0 million at December 31, 2012 and $701,000, or 29.8%, from $2.4 million at June 30, 2012.  OREO increased $86,000, or 12.5%, to $772,000 at June 30, 2013 from $686,000 at December 31, 2012 and decreased $188,000, or 19.6%, from $1.0 million at June 30, 2012.  The OREO at June 30, 2013, consisted primarily of residential and commercial real estate property.  We are actively marketing all properties and none are being held for investment

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purposes.  Repossessed assets decreased $438,000, or 62.2%, to $266,000 at June 30, 2013, from $704,000 at December 31, 2012 and $122,000, or 31.4%, from $388,000 at June 30, 2012.

Reorganization

During the second quarter of 2013, we completed the closure of Southside Securities, Inc.

Recent Accounting Pronouncements

See “Note 1 – Basis of Presentation” in our financial statements included in this report.


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ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The disclosures set forth in this item are qualified by the section captioned “Forward-Looking Statements” included in “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this report and other cautionary statements set forth elsewhere in this report.

Refer to the discussion of market risks included in “Item 7A.  Quantitative and Qualitative Disclosures About Market Risks” in our Annual Report on Form 10-K for the year ended December 31, 2012.  There have been no significant changes in the types of market risks we face since December 31, 2012.

In the banking industry, a major risk exposure is changing interest rates.  The primary objective of monitoring our interest rate sensitivity, or risk, is to provide management the tools necessary to manage the balance sheet to minimize adverse changes in net interest income as a result of changes in the direction and level of interest rates.  Federal Reserve Board monetary control efforts, the effects of deregulation, the current economic downturn and legislative changes have been significant factors affecting the task of managing interest rate sensitivity positions in recent years.

In an attempt to manage our exposure to changes in interest rates, management closely monitors our exposure to interest rate risk through our ALCO.  Our ALCO meets regularly and reviews our interest rate risk position and makes recommendations to our board for adjusting this position.  In addition, our board reviews our asset/liability position on a monthly basis.  We primarily use two methods for measuring and analyzing interest rate risk:  net income simulation analysis and MVPE modeling.  We utilize the net income simulation model as the primary quantitative tool in measuring the amount of interest rate risk associated with changing market rates.  This model quantifies the effects of various interest rate scenarios on projected net interest income and net income over the next 12 months.  The model was used to measure the impact on net interest income relative to a base case scenario of rates increasing 100 and 200 basis points or decreasing 100 and 200 basis points over the next 12 months.  These simulations incorporate assumptions regarding balance sheet growth and mix, pricing and the repricing and maturity characteristics of the existing and projected balance sheet.  The impact of interest rate-related risks such as prepayment, basis and option risk are also considered.  As of June 30, 2013, the model simulations projected that 100 and 200 basis point immediate increases in interest rates would result in negative variances on net interest income of 5.90% and 7.52%, respectively, relative to the base case over the next 12 months, while an immediate decrease in interest rates of 100 and 200 basis points would result in a negative variance in net interest income of 1.93% and 1.31%, respectively, relative to the base case over the next 12 months.  As of June 30, 2012, the model simulations projected that 100 and 200 basis point immediate increases in interest rates would result in positive variances on net interest income of 7.83% and 5.71%, respectively, relative to the base case over the next 12 months, while an immediate decrease in interest rates of 100 and 200 basis points would result in a negative variance in net interest income of 4.23% and 7.31%, respectively, relative to the base case over the next 12 months.  As part of the overall assumptions, certain assets and liabilities have been given reasonable floors.  This type of simulation analysis requires numerous assumptions including but not limited to changes in balance sheet mix, prepayment rates on mortgage-related assets and fixed rate loans, cash flows and repricing of all financial instruments, changes in volumes and pricing, future shapes of the yield curve, relationship of market interest rates to each other (basis risk), credit spread and deposit sensitivity.  Assumptions are based on management’s best estimates but may not accurately reflect actual results under certain changes in interest rates.

The ALCO monitors various liquidity ratios to ensure a satisfactory liquidity position for us.  Management continually evaluates the condition of the economy, the pattern of market interest rates and other economic data to determine the types of investments that should be made and at what maturities.  Using this analysis, management from time to time assumes calculated interest sensitivity gap positions to maximize net interest income based upon anticipated movements in the general level of interest rates.  Regulatory authorities also monitor our gap position along with other liquidity ratios.  In addition, as described above, we utilize a simulation model to determine the impact of net interest income under several different interest rate scenarios.  By utilizing this technology, we can determine changes that need to be made to the asset and liability mixes to mitigate the change in net interest income under these various interest rate scenarios.

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ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures
In our Quarterly Report on Form 10-Q for the quarter ended June 30, 2013, originally filed August 7, 2013, our management, including our Chief Executive Officer (“CEO”) and our Chief Financial Officer (“CFO”), undertook an evaluation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended, (the “Exchange Act”)) as of June 30, 2013 and, based on that evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of that time, in recording, processing, summarizing and reporting in a timely manner the information that the Company is required to disclose in its reports under the Exchange Act and in accumulating and communicating to the Company’s management, including the Company’s CEO and CFO, such information as appropriate to allow timely decisions regarding required disclosure. Subsequent to that evaluation and in connection with the restatement and filing of this amendment, our management, including our CEO and CFO, re-evaluated the effectiveness of our disclosure controls and procedures as of June 30, 2013 and based upon that evaluation, our CEO and CFO have concluded that our disclosure controls and procedures were not effective as of that date because of the material weakness in internal control over financial reporting described below.
Material Weakness in Internal Control Over Financial Reporting
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis.
Specifically, management has identified the following material weakness in internal control over financial reporting as of June 30, 2013:

We did not adequately design interest income recognition controls for municipal securities purchased at a premium. As a result, we did not properly amortize the premium to the maturity of the security, but instead we amortized the premium to the earliest call date. The control deficiency resulted in an interest income recognition error for individual callable municipal securities purchased at a premium that required specific accounting in accordance with generally accepted accounting principles. The error resulted in the restatement of the Company's quarterly financial information as of and for the quarter and year to date period ended June 30, 2013. Management has concluded that the identified control deficiency constitutes a material weakness.

Remediation Plan for Material Weakness

Our management has dedicated significant resources to correcting the accounting error and to ensuring that we take proper steps to improve our internal control over financial reporting in the area of interest income recognition and remedy our material weakness in our internal control over financial reporting and our ineffective disclosure controls and procedures.

Subsequent to December 31, 2013, we enhanced our interest income recognition controls for callable municipal securities purchased at a premium. We will amortize all of our municipal securities purchased at a premium to the maturity date of the security. We believe our remediation efforts, when completed, will be sufficient to remediate the material weakness.

Changes in Internal Control Over Financial Reporting

No changes were made to our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act, as amended) during the quarter ended June 30, 2013 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



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PART II. OTHER INFORMATION

ITEM 1.    LEGAL PROCEEDINGS 

We are party to legal proceedings arising in the normal conduct of business. Management believes that at June 30, 2013 such litigation is not material to our financial position, results of operations or cash flows.

ITEM 1A.    RISK FACTORS

Additional information regarding risk factors appears in “Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations - Forward Looking Statements” of this Form 10-Q/A and in Part I - “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2012.  There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K.

ITEM 2.    UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Not Applicable.


ITEM 3.    DEFAULTS UPON SENIOR SECURITIES

Not Applicable.

ITEM 4.    MINE SAFETY DISCLOSURES

Not Applicable.

ITEM 5.    OTHER INFORMATION

Not Applicable.

ITEM 6.    EXHIBITS

A list of exhibits to this Form 10-Q/A is set forth on the Exhibit Index and is incorporated herein by reference.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 
 
 
SOUTHSIDE BANCSHARES, INC.
 
 
 
DATE:
March 7, 2014
BY:
/s/ SAM DAWSON
 
 
 
Sam Dawson, President and Chief Executive Officer
 
 
 
(Principal Executive Officer)
 
 
 
 
 
 
 
 
 
 
DATE:
March 7, 2014
BY:
/s/ LEE R. GIBSON
 
 
 
Lee R. Gibson, CPA, Senior Executive Vice President and Chief Financial Officer
 
 
 
(Principal Financial Officer)
 
 
 
 
 
 
 
 
 


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Exhibit Index
 
Exhibit Number
 
Description
 
 
 
3 (a)
 
Amended and Restated Articles of Incorporation of Southside Bancshares, Inc. effective April 17, 2009 (filed as Exhibit 3(a) to the Registrant's Form 8-K, filed April 20, 2009, and incorporated herein by reference).
 
 
 
3 (b)
 
Amended and Restated Bylaws of Southside Bancshares, Inc. effective August 9, 2012 (filed as Exhibit 3(b) to the Registrant’s Form 8-K, filed August 10, 2012, and incorporated herein by reference).
 
 
 
*31.1
 
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
 
*31.2
 
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
 
†*32
 
Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
 
*101.INS
 
XBRL Instance Document.
 
 
 
*101.SCH
 
XBRL Taxonomy Extension Schema Document.
 
 
 
*101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document.
 
 
 
*101.LAB
 
XBRL Taxonomy Extension Label Linkbase Document.
 
 
 
*101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document.
 
 
 
*101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document.
 
 
 
*Filed herewith.
 
 
 
 
 
 
† The certification attached as Exhibit 32 accompanies this quarterly report on Form 10-Q/A and is “furnished” to the Commission pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed “filed” by us for purposes of Section 18 of the Securities Exchange Act of 1934, as amended.




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